Question

1) Beta Corp. has a market capitalization rate of 12%, an ROE of 10% and a plowback ratio of 80%. Suppose Beta. Corp decides to pay out 100% of its earnings. What will happen to its P/E ratio?

2) Alpha Corp. has a market capitalization rate of 12%, an ROE of 16% and a plowback ratio of 50%. Suppose Alpha Corp. decides to pay out 100% of its earnings. What will happen to its P/E ratio?

Answer 1

1) This is a very subjective question, considering the firms ROE >> Cost of capital, the firm is making good use of the cash. If they increase the payout ratio, the market could take it as a sign that there are no future growth projects that the company has and the stock price could crash which will lead to a fall in P/E

If that over-hang is not there, then it could be a good signal and the stock price could rise, which will increase the PE

2)

In this case looking at the reutrns profile (ROE - 16%), the Equity holders will appreciate the increased payout and the long term price could increase, causing a rise in the PE ratio

But initially the stock price will fall as of ex dividend data and that will lead to temporary PE reduction