Calculating a Justified Price Multiple

A justified price multiple estimates the fair value of a price multiple that can be justified based on the method of forecasted fundamentals or the method of comparables.

The justified price multiple is the value the multiple would be if the stock were trading at its fair value. Suppose the justified price multiple is higher than the current price multiple. In that case, the stock is undervalued. On the other hand, if the justified price multiple is lower than the current price multiple, the stock is overvalued.

Example: Calculating P/E Based on the Method of Comparables

The stock of a particular company is currently trading at $50. The company’s EPS as of the end of last year was $5. The average trailing P/E for peer companies is $20. Is the company’s stock undervalued, fairly valued, or overvalued?

Solution

$$\text{Trailing}\ \frac{\text{P}}{\text{E}}= \frac{50}{5}=10$$

Since the company’s actual trailing P/E of 10 is lower than the average trailing P/E of peer companies of 20, the stock is relatively undervalued.

Alternatively, using the average trailing P/E for peer companies:

$$\text{Estimated value of the stock} = 5 \times 20 = \$100$$

The company’s actual market price of $50 is lower than its intrinsic value of $100, implying that it is relatively undervalued.

Example: Calculating P/E Based on the Forecasted Fundamentals

Consider the following information:

• Current stock price = $30 per share.
• Next year’s expected EPS = $5
• Dividend payout ratio = 25%
• Required rate of return on equity = 10%
• Long-term growth rate = 4%

Determine the stock’s leading P/E multiple based on its fundamental value using the Gordon growth model.

Solution

$$\begin{align*}\text{Stock’s actual}\ \frac{\text{P}}{\text{E}}&= \frac{30}{5}\\&=6\\ \\
\text{Next year’s expected dividend} &= 5 \times0.25 \\&=1.25\\ \\ \text{Intrinsic value} &=\frac{\text{D}_1}{(\text{r}-\text{g})}\\&= \frac{1.25}{(0.10-0.04)} \\&=\$20.83\\ \\
\text{Leading}\ \frac{\text{P}}{\text{E}}\ \text{ratio}&=\frac{20.83}{5} \\&= 4.17\end{align*}$$

The stock’s actual P/E ratio of 6 is higher than the P/E ratio based on its fundamentals of 4.17. It is therefore overvalued.

Question

Given the information below:

• Current stock price = $28.00
• Most recent EPS = $2.40
• Forecasted EPS = $3.20
• Growth rate = 3%

The trailing P/E ratio is closest to:

1. 75.
2. 67.
3. 25.

Solution

The correct answer is B.

$$\text{Trailing}\ \frac{\text{P}}{\text{E}}= \frac{28.00}{2.40}=11.67$$

Reading 25: Market-Based Valuation: Price and Enterprise Value Multiples

LOS 25 (b) Calculate and interpret a justified price multiple.