Variables Impacting the P/E Ratio

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Memo:The P/E ratio = Dividend Payout Ratio / (ke"" g),

Impact of variables:

To determine which of the statements is most likely FALSE, let's examine each statement and its potential impact on the price/earnings (P/E) ratio:

A. Dividend payout increases, the P/E ratio will increase. When the dividend payout increases, it means that a larger portion of earnings is being distributed to shareholders as dividends. This reduces the retained earnings of the company, which in turn decreases the denominator of the P/E ratio (earnings per share). As a result, the P/E ratio will likely increase since the earnings per share decreases while the stock price remains the same or increases.

B. Expected inflation rate decreases, the P/E ratio will rise above 12.5. The expected inflation rate is not directly related to the P/E ratio. The P/E ratio is influenced by factors such as earnings growth, risk, and market sentiment, among others. While inflation can impact the overall economy and financial markets, it does not have a direct and predictable relationship with the P/E ratio. Therefore, it is most likely FALSE that the P/E ratio will rise above 12.5 solely due to a decrease in the expected inflation rate.

C. Earnings retention ratio increases, the P/E ratio will increase. The earnings retention ratio is the proportion of earnings that a company retains for reinvestment in the business rather than distributing them as dividends. When the earnings retention ratio increases, it means that a larger portion of earnings is being retained. This leads to higher retained earnings, which increases the denominator of the P/E ratio (earnings per share). Consequently, the P/E ratio will likely increase since the earnings per share increases while the stock price remains the same or increases.

D. Risk-free rate increases, the P/E ratio will decrease. The risk-free rate is the hypothetical rate of return on an investment with zero risk, such as a government bond. An increase in the risk-free rate raises the discount rate used to value future cash flows, including earnings, and increases the required rate of return for investors. This increased required rate of return can lead to a decrease in the P/E ratio, as investors demand higher returns to compensate for the increased risk. Therefore, it is likely TRUE that an increase in the risk-free rate will decrease the P/E ratio.

Based on the above analysis, the statement that is most likely FALSE is: B. Expected inflation rate decreases, the P/E ratio will rise above 12.5.

It is important to note that the relationship between variables and the P/E ratio can be influenced by various other factors and market conditions. Therefore, while the explanations provided above are generally true, real-world situations may exhibit different outcomes.