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
A benchmark Price-to-Earnings (PE) ratio can be determined using the constant-growth model, also known as the Gordon Growth Model (GGM). This model helps estimate the intrinsic value of a stock based on its expected dividends, required return, and growth rate. The formula is:
[
P_0 = \frac{D_1}{r – g}
]
where:
- ( P_0 ) = stock price
- ( D_1 ) = expected dividend next year
- ( r ) = required rate of return
- ( g ) = constant dividend growth rate
To derive the PE ratio, we divide both sides by earnings per share (EPS):
[
PE = \frac{1 – b}{r – g}
]
where ( b ) is the retention ratio (portion of earnings retained). This equation shows that the PE ratio depends on the required return and growth expectations.
Why Not Other Options?
- Bank of Canada estimates the PEs of similar companies
- While industry comparisons are useful for relative valuation, they do not determine a benchmark PE based on fundamental financial principles. Different firms have unique risks and growth expectations.
- A company’s own historical PEs
- Past PE ratios provide insight into valuation trends but do not set a benchmark. Market conditions, interest rates, and growth expectations change over time, making historical PEs unreliable for future valuation.
Conclusion
The constant-growth model provides a theoretical and forward-looking approach to estimating a benchmark PE ratio based on expected returns and growth. It helps investors assess whether a stock is overvalued or undervalued relative to its fundamental characteristics.