Chartered Financial Analyst (CFA) Practice Exam Level 2

What does the variable "b" represent in the P/E ratio formulas?

1. The expected growth rate

2. The payout ratio

3. The plowback ratio

4. The return on equity

The correct answer is: The plowback ratio

In the context of the P/E ratio, the variable "b" refers to the plowback ratio, which is a critical component in determining how much of a company's earnings are retained for reinvestment in the business versus how much is paid out as dividends to shareholders. The plowback ratio, also known as the retention ratio, indicates the portion of earnings that is not distributed as dividends. This retained portion is often used for reinvestment in the company, such as funding expansion projects or paying off debt. In financial models, an understanding of the plowback ratio helps analysts assess the potential future growth of a company. When considering the P/E ratio and its relation to growth, the underlying assumption is that the growth in earnings (and thus potentially in stock price) can be partially attributed to how much earnings are reinvested in the business. The more a company retains to plow back into growth initiatives, the higher the potential future earnings, which can lead to a higher P/E ratio. While the other options like the expected growth rate, payout ratio, and return on equity are related concepts, they do not represent the meaning of "b" in the P/E ratio formulas directly. The expected growth rate is influenced by