Practice Problem – Impact of Payout Ratio on P/E

Practice Question

Cases in Finance
Valuation Tools
Multiples
Short Answer

What is the impact of increasing the payout ratio on the P/E ratio, assuming constant growth?

Answer +
B
Explanation +

Under the Gordon Growth Model, the P/E ratio is influenced by the payout ratio and the growth rate:

P/E = (Payout Ratio) / (r - g),

where r is the required return and g is the growth rate of earnings.

Increasing the payout ratio reduces the retention ratio, which lowers the growth rate g (since growth = retention × ROE). A lower growth rate increases the denominator in the P/E formula, resulting in a lower P/E ratio.