The justified price to earnings ratio is the price to earnings ratio that is “justified” by using the Gordon Growth Model. This version of the popular 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 simply “justified P/E”, this variation of the standard P/E metric is frequently used by market analysts and investors.
Analyzing the Justified Price to Earnings 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.
The GGM is a discount model that factors in stock dividends to estimate a stock’s intrinsic value, based on an assumption of future, consistent dividend growth. The GGM is used to calculate the fair market value 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:
P – the current fair market 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.
Alternatively, the justified price to earnings ratio calculation can be presented in a different way, using the payout ratio.
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 most often used to predict the future performance of a stock.
When the justified P/E figure is close to identical to the stock’s forward P/E figure, many market analysts interpret that 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.
If the justified P/E is greater than the forward P/E, then the stock is likely undervalued/underpriced. Alternatively, if the justified P/E is lower than the stock’s forward P/E, all other things being equal, the stock is considered overvalued at its current price.
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 – or under- or overvalued. This kind of information can be crucial in helping traders make smart buying or selling moves in the stock market.
Example in Excel
Below are an example and template of how to calculate and compare the justified price to earnings ratio and the standard price to earnings ratio in Excel.
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