In explaining the factors in the dividend discount model that affect a stock's expected price-to-earnings (/) ratio, which of the following statements is least accurate? Holding other factors constant:
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A. B. C.C
In the dividend discount model (DDM), the expected price-to-earnings (P/E) ratio of a stock is influenced by several factors. Let's evaluate each statement provided and determine the least accurate one.
A. As the difference between k (required rate of return on the stock) and g (expected constant growth rate of dividends) widens, the value of P/E decreases.
This statement is accurate. The P/E ratio is inversely related to the difference between the required rate of return (k) and the expected growth rate of dividends (g). The P/E ratio represents the market's valuation of a stock relative to its earnings. When the difference between k and g widens, it suggests that the stock's growth prospects are not meeting investors' required rate of return. As a result, investors are willing to pay a lower price relative to earnings, leading to a decrease in the P/E ratio.
B. As g increases, the value of P/E increases.
This statement is also accurate. A higher expected constant growth rate of dividends (g) implies that the company is expected to experience stronger earnings growth in the future. When the growth prospects improve, investors become more optimistic about the stock's future earnings potential. As a result, they are willing to pay a higher price for the stock relative to its earnings, leading to an increase in the P/E ratio.
C. As the expected dividend payout ratio decreases, the value of P/E increases.
This statement is inaccurate. The dividend payout ratio refers to the proportion of earnings that a company distributes as dividends. A decrease in the expected dividend payout ratio implies that the company retains a larger portion of its earnings to reinvest in the business, rather than distributing them as dividends. This retained earnings can be used for future growth opportunities, which may lead to higher earnings and increased investor expectations. Consequently, a decrease in the expected dividend payout ratio is generally associated with higher growth prospects and can result in an increase in the P/E ratio, not the other way around.
Therefore, the least accurate statement is C.