Zero Retention rate

[June07_guy]

If a company has an earnings retention rate of zero, its P/E ratio will be which of the following?

A. 1/g
B. 1/k
C. D/P+g
D. D/k-g

By guess, you would say the answer is B, which is correct, but it is not clear why g is assumed to be zero. i.e., they are using P/E= (D/E)/k-g, and since D/E = 1 as all earnings are paid out in dividends, the answer should be 1/k-g.

True the payout raio is constant = 1, but how can we say that the dividends growth rate is zero? For example, the company's earnings could be growing at 10%, which means dividends are also growing at 10%.
Guy

 

[patkeenan]

g = ROE x RR
if RR = 0
g = ROE x 0
g = 0

 

[June07_guy]

Good answer, thanks for pointing this out. However, it still looks funny. This really says that if your required rate of return is (for example) 12%, then the following two stocks will have the same P/E:

1) Stock A pays out all of its earnings, but its earnings are a constant $1 every year.

2) Stock B pays out all of its earnings, but its earnings are grwoing at 20% per year.

Guy

 

[patkeenan]

g represents the growth rate of both dividends and earnings. If the company has 0 rentention rate then it is not investing anything into itself, thus it has no capacity to grow.
so for your example, stock B would have to have a retention rate > 0 in order to facilitate the growth of 20%.



Edited 1 time(s). Last edit at Friday, April 13, 2007 at 10:21PM by patkeenan.

 

[June07_guy]

Good point. Thanks.

 

[patkeenan]

no problem