Is Justified P/E ratio same as Standard P/E ratio? Let's find it out in the below article!
Justified P/E associates a particular value of the P/E with a set of forecasts of the fundamentals and the dividend payout ratio.
The valuation of a company is a critical aspect for analysts and investors studying a potential company for investment purposes. The most commonly used, valuation metric is the price-to-earnings ratio which is, defined as the ratio for the valuation of the company, which measures its current share price relative to its earnings per share (EPS).
There are also several models to determine the absolute values of the company based on its dividend stream. Gordon Growth Model (GGM) is one of the popular names, which calculates the intrinsic value of the firm or company using the expected dividend per share, required rate of return, and expected dividend growth rate. The standard PE ratio is connected with the GGM to obtain a justified PE ratio.
The formula for Gordon Growth Model = Next Period DPS / (r – g)
where,
DPS - dividend per share
g - expected growth rate
r- required rate of return
Justified price-to-earnings ratio is the price-to-earnings ratio that is ‘justified’ by using Gordon Growth Model. There are two types of Justified P/E ratio i.e. Justified Trailing P/E ratio and Justified Forward or Leading P/E ratio. Trailing P/E ratio is used to evaluate a stock’s historical track record while Forward or Leading P/E is most often used to predict the future performance of a stock.
Let's have a look at both the formulas:
Justified Forward or Leading P/E ratio = [(Next Period DPS/EPS)] / (r – g)
Justified Trailing P/E ratio = [(Current Period DPS * (1+g) / EPS)] / (r – g)
where,
DPS - dividend per share
EPS - earnings per share
DPS/EPS - payout ratio
g - expected growth rate
r- required rate of return
Justified Forward or Leading P/E ratio considers DPS expected for the next year whereas Justified Trailing P/E ratio considers the already-paid DPS for the current year and incorporates the expected growth rate.
Justified P/E associates a particular value of the P/E with a set of forecasts of the fundamentals and the dividend payout ratio. Keeping all else constant, the higher the expected dividend growth rate or the lower the stock’s required rate of return, the higher the stock’s intrinsic value and the higher its justified P/E.
This ratio is compared with the standard PE ratio, which is based on the current market price to determine whether the stock is under or overvalued.