Justified P/E ratio

CFA Level III Equities
#1

Hey everyone, I was wondering if someone could shed some light onto the term Justified P/E ratio. What is the difference between a justified P/E ratio and the normal P/E ratio in its meaning/calculation? Thank you for all of your help! Good luck studying!

#2

Don’t know what you mean by normal, maybe you have a particular calculation in mind. What I remember from L.2 is that we have trailing P.E. which is based on the past and is given as: Justified PE=(Payout Ratio)(1+g)/(r-g) Also we have the forward P.E. which is based on future growth in earnings and is equal to Forward PE=(Payout Ratio)/(r-g) As you can see the two differ by a growth term, so given current earnings , payout ratio and price, the frm should become (1+g) times cheaper to own owing to growth

#3

I thought it is level II stuff, no? Justified PE can be either leading/forward or trailing. It is the P/E derived from expected payout ratio, expected return and growth rate. o Leading= (1-b)/(r-g) o Trailing= (1-b) (1+g)/(r-g) It is different from real P/E which is just Price/Earnings. Comparing those two ratios can give you indication whether the stock is ‘overvalued’ or not.

#4

elcfa Wrote: ------------------------------------------------------- > I thought it is level II stuff, no? > > Justified PE can be either leading/forward or > trailing. It is the P/E derived from expected > payout ratio, expected return and growth rate. > > o Leading= (1-b)/(r-g) > o Trailing= (1-b) (1+g)/(r-g) > > It is different from real P/E which is just > Price/Earnings. Comparing those two ratios can > give you indication whether the stock is > ‘overvalued’ or not. Elcfa is right. Justified PE is what the PE should be based on “forecasted” fundamentals while what you call the “normal” PE is the current market price divided by the earnings which may be leading (future earnings) or trailing (previous earnings). If the justified forward PE is higher than “normal” PE, then the stock is undervalued…

#5

What’s the difference between forward p/e and justified forward p/e?

#6

justified forward p/e is based on fundamentals of expected EPS.

forward p/e is based on stock price divided by expected EPS.

justified forward p/e > forward p/e means stock is undervalued

#7

There.

That’s better.

#8

The expected eps in forward p/e is also based on fundamentals, no?

#9

Yes.

#10

Hi S2000magician,

I’ve recently bumped into a CFA problem where comparing the justified (fundamental) P/E to the forward P/E was deemed incorrect, as the solution said that the forward P/E is not based on fundamentals and that the justified P/E should be compared to trailing P/E. Would you agree with this approach/explanation?

Thanks

#11

It depends on how the expected EPS is determined. If it’s simply the trailing EPS multiplied by an historic growth rate, then it’s based on fundamentals. If it’s plucked from thin air, then not so much.

1 Like
#12

Makes perfect sense - apparently, the person who created the problem assumed the latter. :smiley:

Appreciate the quick turnaround and have a good one!

#13

My pleasure.