Increasing Dividend Growth Rate

Factors Affecting P/E Ratio

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Question

Increasing which factor in the dividend discount model, without changing the other two, would be least likely to increase a stock's price-to-earnings (P/E) ratio?

Answers

A. The expected dividend payout ratio.

B. The required rate of return on the stock.

C. The expected constant growth rate of dividends.

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Explanations

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A. B. C.

Let's analyze the given question and the answer options:

The question asks about increasing a factor in the dividend discount model (DDM) without changing the other two factors, and which of these changes would be least likely to increase a stock's price-to-earnings (P/E) ratio.

The dividend discount model (DDM) is a valuation method used to determine the intrinsic value of a stock based on its future dividends. It assumes that the value of a stock is the present value of all expected future dividends. The formula for the DDM is as follows:

$P_0 = \frac{D_1}{r - g}$

where:

$P_0$ is the stock's current price,
$D_1$ is the expected dividend at the end of the first period,
$r$ is the required rate of return on the stock,
$g$ is the expected constant growth rate of dividends.

Now let's analyze each answer option and its impact on the P/E ratio:

A. The expected dividend payout ratio: The dividend payout ratio is the proportion of earnings that a company pays out as dividends to its shareholders. Increasing the expected dividend payout ratio means that a larger portion of earnings will be paid out as dividends. This would lead to higher dividends in the DDM formula, which would increase the stock's price ( $P_0$ ). As a result, the P/E ratio (which is calculated by dividing the stock price by earnings per share) would increase, assuming earnings remain constant. Therefore, increasing the expected dividend payout ratio would likely increase the P/E ratio.

B. The required rate of return on the stock: The required rate of return represents the minimum return an investor expects from an investment. Increasing the required rate of return (assuming dividends and growth rate remain constant) would decrease the stock's price ( $P_0$ ) in the DDM formula. As a result, the P/E ratio would increase because the denominator (stock price) decreases while earnings per share remain constant. Therefore, increasing the required rate of return would likely increase the P/E ratio.

C. The expected constant growth rate of dividends: The constant growth rate of dividends reflects the expected rate at which dividends will grow in the future. Increasing the expected growth rate of dividends (assuming required rate of return and dividend payout ratio remain constant) would increase the stock's price ( $P_0$ ) in the DDM formula. However, this increase in stock price would be counterbalanced by the increase in expected dividends, resulting in a relatively unchanged P/E ratio. Therefore, increasing the expected constant growth rate of dividends would be least likely to increase the P/E ratio.

In conclusion, among the given options, increasing the expected constant growth rate of dividends (Option C) would be least likely to increase a stock's price-to-earnings (P/E) ratio.

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