Can someone explain the difference between justified P/E and forward P/E. The IFT notes I have say that if the forward P/E is higher than the justified P/E, then the stock is overvalued. But to me, when I read the notes regarding these ratios, it looks like a forward P/E is a type of justified P/E… the presentation of the notes is confusing.
Than probably the presentation you are reading is not good?
Forward P/E is based on market price, while the justified P/E (leading or trailing) is based on valuation, it’s an intrinsic and not a market price. Hence if it is less than the market based P/E, the stock is overvalued by the market.
Justified P/E you calculate (1-b)/(r-g) the leading, and (1-b)x(1+g)/(r-g) the trailing.
It’s the difference between what is (forward P/E) and what should be (justified P/E).
If it helps you to remember, the whole idea of Justified P/E is that it represents the valuation of a stock under the assumption that all relevant information is available to the valuer. Knowing all relevant information you could say that you are ‘justified’ in the valuation you have placed on the stock.Forward P/E does not carry this assumption (it is simply market implied).
Therefore, in the simplest of terms, if the Forward P/E is higher than the Justified P/E, it implies that there must be some other information out there to suggest that the stock should not be trading at its current price. The stock is therefore overvalued as measured by the Forward P/E.
Hope that helps a little bit.