With Risk
With Dividend
6/19/2020
Ahmed Shahzad, PhD Scholar
1
P/E with Risk

 P/E ratio Not only reflect the market ’ s views of the
company ’ s growth prospects, it also indicates the
market ’ s views of its risk profile.
 P/E ratio = payout ratio x 1/(Ke - g)
 This means that the P/E ratio is affected both by the
forecast growth (g) and also by the cost of equity
(Ke).
6/19/2020
Ahmed Shahzad, PhD Scholar
2
P/E ratio = payout ratio x 1/(Ke - g)

 If g rises, the P/E goes up. But if Ke rises, the P/E
goes down.
 If the market perception of the company ’ s risk
increases, the discounted value of its future cash
flows will be lower, and thus its price will fall; this
being the case, it will trade on a lower P/E ratio,
Because CF is discounted on higher Rate.
6/19/2020
Ahmed Shahzad, PhD Scholar
3
P/E with Risk

 An increase in the EPS which was driven by taking
on excessive risk could actually cause the share price
(and the P/E ratio) to fall rather than rise.
6/19/2020
Ahmed Shahzad, PhD Scholar
4
THE P/E RATIO AND DIVIDENDS

 One further misconception is that the dividend
payout ratio can be used to manipulate the share
price. (companies do to attract more shareholders in
the market)
6/19/2020
Ahmed Shahzad, PhD Scholar
5
THE P/E RATIO AND DIVIDENDS

 P/EPS = D1/EPS x 1/(Ke - g)
 At first sight, it might appear that the P/E ratio – and
thus the share price – could be increased merely by
increasing the dividend payout ratio;
 paying a higher percentage of profits out to the
shareholders would have a direct impact on prices.
6/19/2020
Ahmed Shahzad, PhD Scholar
6
THE P/E RATIO AND DIVIDENDS

 This argument is flawed. The company generates
funds which can be used either to pay out dividends
or to reinvest in the future growth of the business.
 If the company were to increase the dividend payout
ratio, fewer funds would be available for
reinvestment and so (presumably) future growth
would be less than otherwise anticipated
6/19/2020
Ahmed Shahzad, PhD Scholar
7
THE P/E RATIO AND DIVIDENDS

 Thus, although the function D1/EPS in equation
 P/EPS = D1/EPS x 1/(Ke - g) would increase, the
denominator (Ke – g) would also increase as g fell.
 Accordingly, there is not necessarily a simple
arithmetical relationship between changes in the
dividend payout ratio and changes in the share price.
So it this argument is flawed.
6/19/2020
Ahmed Shahzad, PhD Scholar
8