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Justified Price-to-Earnings Ratio

Another look at the price-to-earnings ratio.

What is the Justified Price-to-Earnings Ratio?

The justified price-to-earnings ratio is the price-to-earnings ratio for a company that is ‘justified’ by the Gordon Growth Model. This version of the P/E ratio uses a variety of underlying fundamental factors such as cost of equity and growth rate. Commonly shortened to justified P/E ratio or justified P/E, it is a variation of the standard P/E metric, frequently used by market analysts and investors.

 

Justified Price-to-Earnings Ratio Opener

 

Analyzing the Justified P/E Ratio

The justified price-to-earnings ratio is determined by connecting the traditional P/E ratio to the Gordon Growth Model (GGM).

The P/E ratio compares the current valuation of a company’s common stock shares to the company’s earnings.

 

Justified Price-to-Earnings Ratio - Price to Earnings Ratio

 

The GGM is a discount model that factors in stock dividends to estimate a stock’s intrinsic value, based on future, consistent dividend growth. The GGM is used to calculate the price of a stock. In the justified price-to-earnings ratio calculation, we use the price derived from the GGM to find the justified P/E.

The GGM is calculated as follows:

 

Justified Price-to-Earnings Ratio - GGM

 

 

Where:

  • P – the current price for the company’s stock
  • D_0 – the dividend per share
  • r_E – the cost of equity
  • g – the company’s projected growth rate for the immediate future

 

To determine the justified P/E – also referred to as the fundamental P/E – both sides of the equation need to be divided by the earnings per share that are expected for the following year.

 

Justified Price-to-Earnings Ratio

 

Alternatively, the justified price-to-earnings ratio calculation can also be presented in a different way, using the payout ratio.

 

Justified Price-to-Earnings Ratio - Alt

 

Using the Justified P/E Ratio

The justified price-to-earnings ratio can be compared with other stock evaluation metrics such as the standard P/E, trailing P/E, and forward P/E. The trailing P/E is useful for evaluating a stock’s historical track record, while the forward P/E is often used to predict the future performance of a stock.

When the justified P/E figure is close to identical to a stock’s forward P/E figure, many market analysts interpret it as an indication that the company’s stock is priced fairly, based on historical price movements, cost of equity, and the company’s current and future projected growth rate.

Meanwhile, if justified P/E is greater than a stock’s forward P/E, the stock is likely underpriced. Alternatively, if justified P/E is lower than a stock’s forward P/E, it is likely overpriced.

Determining a company’s justified P/E is important for analysts and traders because it helps them to determine if a company is valued fairly – if it under or overvalued. The information can be crucial in helping traders make buying or selling moves in the stock market.

 

Example of Justified P/E Ratio in Excel

Below is an example and template of how to calculate and compare justified price-to-earnings ratio and the standard price-to-earnings ratio in Excel.

 

Justified Price to Earnings Ratio - Excel

 

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Additional Resources

CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

  • Balance Sheet
  • Cash Flow Statement
  • Dividend Per Share (DPS)
  • PEG Ratio

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