 # 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.

• 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

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

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

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

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