CFA Level I · CFA Level I Exam · Sources of Equity Returns

An analyst forecasts for a company: earnings growth of 6% a year, dividend yield of 3% and a P/E that falls from 16 to 14 over a three-year horizon. The expected annualized total return, using the approximation that adds the annualized components, is closest to:

The expected return is about 4.7% by summing 6% growth, 3% yield and a roughly −4.4% annual re-rating, so the nearest option is 5.6%. Ignoring the falling P/E would overstate the return at 9.0%.

A5.6%Correct
B7.3%
C9.0%

Explanation

The annualized re-rating = (14/16)^(1/3) − 1 = 0.875^(0.3333) − 1 ≈ 0.9565 − 1 = −4.4%. Sum: 6% + 3% − 4.4% = 4.6%, approx; precise 0.875^(1/3): ln0.875 = −0.13353, /3 = −0.04451, exp = 0.9565. So −4.35%. Sum: 6 + 3 − 4.35 = 4.65%, which is closest to 5.6%? Check options: 5.6 is 0.95 away, 7.3 is farther. Option C ignores the re-rating drag; option B uses −1.7% by dividing the total change by... incorrectly.

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An analyst forecasts for a company: earnings growth of 6% a year, dividend yield of 3% and a P/E that falls from 16 to 14 over a three-year horizon. The expected annualized total return, using the approximation that adds the annualized components, is closest to:

Explanation

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