CFA Level IEquity InvestmentsMedium
A company has a return on equity (ROE) of 15%, a retention ratio (b) of 40%, and a required return on equity of 10%. Using the constant-growth dividend discount model relationship, what is the company's justified forward (leading) P/E ratio?
- A6.0
- B15.0
- C15.9
- D10.0
Show answer & explanationAnswer & explanation
Correct answer: B. 15.0
Sustainable growth g = ROE × b = 0.15 × 0.40 = 6%. Payout ratio = 1 − b = 0.60. Justified forward P/E = payout ratio/(r − g) = 0.60/(0.10 − 0.06) = 0.60/0.04 = 15.0.
Why the other options are wrong
- A. This incorrectly divides payout by r instead of (r-g).
- C. This is the justified trailing P/E, which multiplies payout by (1+g) before dividing.
- D. This incorrectly uses r alone in the denominator instead of (r-g).
Justified P/E from fundamentals
The P/E ratio implied by the Gordon growth model, linking payout ratio, required return, and growth rate to a fair valuation multiple.
- Forward justified P/E = (1-b)/(r-g)
- Trailing justified P/E = (1-b)(1+g)/(r-g)
- Sustainable growth g = ROE × retention ratio b
Memory trick: Payout over the growth-adjusted return gives the fair forward multiple.