A benchmark PE ratio can be determined using:
Bank of Canada estimates the PEs of similar companies
a company’s own historical PEs
the constant-growth model
The correct answer and explanation is :
The correct answer is:
The constant-growth model
Explanation:
The Price-to-Earnings (PE) ratio is a fundamental valuation metric used to assess whether a stock is overvalued or undervalued. A benchmark PE ratio represents a standard or reference point to compare a company’s current PE ratio. Among the given options, the constant-growth model (Gordon Growth Model) is the appropriate method to determine a benchmark PE ratio.
1. The Constant-Growth Model and PE Ratio
The constant-growth dividend discount model (DDM) is given by:
[
P_0 = \frac{D_1}{r – g}
]
Where:
- ( P_0 ) is the current stock price
- ( D_1 ) is the expected dividend in the next period
- ( r ) is the required rate of return
- ( g ) is the constant dividend growth rate
By dividing both sides by earnings per share (EPS), we get the intrinsic PE ratio:
[
PE = \frac{1 – b}{r – g}
]
Where ( b ) is the earnings retention ratio (1 – dividend payout ratio).
This equation shows how a company’s growth rate, return expectations, and dividend policies determine its PE ratio, making it a benchmark for valuation.
2. Why Other Options Are Incorrect
- Bank of Canada estimates the PEs of similar companies: This provides a relative PE comparison, but it does not establish a theoretical benchmark.
- A company’s own historical PEs: Past PEs reflect past market conditions and investor sentiment, but they do not determine a fair or justified PE based on fundamentals.
Thus, the constant-growth model provides the most theoretically sound benchmark for the PE ratio.