Justified P/Es

CFA Level II Equities
#1

I did a quick search on here and my question builds off of this one: http://www.analystforum.com/forums/cfa-forums/cfa-level-ii-forum/91153781

I now understand that justified refers to using an intrinsic value instead of the price the stock trades at.

Questions: 1. Why do the formulas look at dividends? (Page 105 of 2013 CFA Level 2 Schweser notes) Can we not estimate an intrinsic value without focusing on dividends and retention ratios?

  1. In question that want a justified P/E ratio, we might as well just ignore the stock price, right? It seems like it’s only there to trick us in most cases. Is my understanding correct?
#2

  1. I don’t know what book you are referring to, I looked at my equity book and didn’t find justified P/Es there. But in my CFA book regarding justified P/Es it says, “The simplest of all DCF models is the Gordon (constant) growth form of the dividend discount model (DDM).” I think they choose dividends as the basis for the formula because they believe it is the simplest way of explaining DCF. I suppose in real life you could use free cash flow too.

  2. You ignore the stock price when calculating the justified P/E ratio. But you use the current stock price to figure out if its undervalued or overvalued based on your justified P/E calculations.