Question

Two Companies, Gamma and Theta have justified forward P/E ratios of 12.59x and 14.29x respectively. Their ROE and payout ratios are :
Gamma = ROE 13.5% , Payout Ratio 45%
Theta = ROE 15% , Payout Ratio 50%
The required rate of return is 11%, If Gamma's payout ratio increase to 55% and Theta's payout ratios decreases to 40%, what would be the most likely resultant effect on their justified P/E ratios ?
a. Gamma's P/E ratios will increase but Theta's P/E ratio will decrease
b. Gamma's P/E ratios will decrease but Theta's P/E ratio will increase
c. Both P/E ratios will increase

Answer 1

Let's first examine the relationship between the three variables namely Forward P/E ratio, payout ratio and growth rate.

The relationship is evident in the relationship shown below:

where K_e = Required rate of return = 11%

and g = sustainable growth rate = Retention ratio x ROE = (1 - payout ratio) x ROE

Gamma = ROE 13.5% , New Payout Ratio 55%; Hence g= (1 - 55%) x 13.5% = 6.08%

Hence, New Forward PE = 55% / (11% - 6.08%) = 11.17x

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Theta = ROE 15% , New Payout Ratio 40%

Hence g= (1 - 40%) x 15% = 9.00%

Hence, New Forward PE = 40% / (11% - 9.00%) = 20.00x

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Hence, the correct answer is option (b). Gamma's P/E ratios will decrease but Theta's P/E ratio will increase