Calculating a Justified Price Multiple

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?


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

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.


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

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.


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.


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.

Shop CFA® Exam Prep

Offered by AnalystPrep

Featured Shop FRM® Exam Prep Learn with Us

    Subscribe to our newsletter and keep up with the latest and greatest tips for success
    Shop Actuarial Exams Prep Shop Graduate Admission Exam Prep

    Daniel Glyn
    Daniel Glyn
    I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
    michael walshe
    michael walshe
    Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.
    Nyka Smith
    Nyka Smith
    Every concept is very well explained by Nilay Arun. kudos to you man!
    Badr Moubile
    Badr Moubile
    Very helpfull!
    Agustin Olcese
    Agustin Olcese
    Excellent explantions, very clear!
    Jaak Jay
    Jaak Jay
    Awesome content, kudos to Prof.James Frojan
    sindhushree reddy
    sindhushree reddy
    Crisp and short ppt of Frm chapters and great explanation with examples.