Calculating and Interpreting a Predicted P/E

Calculating and Interpreting a Predicted P/E

A predicted P/E is estimated from the cross-sectional regressions of P/E on the fundamentals that are considered to determine investment value, e.g., the growth rate of earnings and payout ratio.

Example: Calculating a Predicted P/E

Consider a firm with a beta of 0.8, a dividend payout ratio of 0.40, and an earnings growth rate of 0.09. The estimated regression for a group of stocks in the same industry is:

$$\text{Predicted P/E} = 11.12 + (2.15\times\text{DPR}) – (0.15\times\text{Beta}) + (12.43\times\text{EGR})$$

Where DPR is the dividend payout ratio, and EGR is the five-year earnings growth rate.

Based on this cross-sectional regression, the company’s predicted P/E is 12.979.

$$ \begin{align*} \text{Predicted P⁄E} & =11.12+(2.15 \times 0.40)-(0.15 \times 0.8)+(12.43 \times 0.09) \\ & = 12.979 \end{align*} $$

If the stock’s actual trailing P/E is 17, the stock is overvalued as it is selling at a higher multiple than is justified P/E by its fundamentals.

The predicted P/E has three limitations:

  1. It summarizes valuation relationships only for the specific stock over a particular period. The relationship may have poor predictive quality when applied to other stocks or outside the sample period.
  2. The relationship between company fundamentals and P/E changes over time, diminishing the model’s predictive power.
  3. Such regressions tend to suffer from multicollinearity making it difficult to interpret individual regression coefficients.


A company has a beta of 0.6, a dividend payout ratio of 0.30, and an earnings growth rate of 0.07. The predicted P/E is closest to:

  1. 12.62.
  2. 14.50.
  3. 16.32.


The correct answer is A.

$$\begin{align*}\text{Predicted P/E}& = 11.12 + (2.15\times\text{DPR}) – (0.15\times\text{Beta}) \\ & + (12.43\times\text{EGR})\\&= 11.12 + (2.15 \times 0.30)– (0.15 \times 0.6)+ (12.43 \times 0.07)\\&=12.62\end{align*}$$

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

LOS 25 (i) Calculate and interpret a predicted P/E, given a cross-sectional regression on fundamentals, and explain limitations to the cross-sectional regression methodology.

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.