{"id":19844,"date":"2021-08-18T12:38:59","date_gmt":"2021-08-18T12:38:59","guid":{"rendered":"https:\/\/analystprep.com\/study-notes\/?p=19844"},"modified":"2024-04-05T06:45:51","modified_gmt":"2024-04-05T06:45:51","slug":"calculating-a-justified-price-multiple","status":"publish","type":"post","link":"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/calculating-a-justified-price-multiple\/","title":{"rendered":"Calculating a Justified Price Multiple"},"content":{"rendered":"<p><iframe loading=\"lazy\" src=\"\/\/www.youtube.com\/embed\/0kMmbenpFuo\" width=\"611\" height=\"343\" allowfullscreen=\"allowfullscreen\"><span data-mce-type=\"bookmark\" style=\"display: inline-block; width: 0px; overflow: hidden; line-height: 0;\" class=\"mce_SELRES_start\">\ufeff<\/span><span data-mce-type=\"bookmark\" style=\"display: inline-block; width: 0px; overflow: hidden; line-height: 0;\" class=\"mce_SELRES_start\">\ufeff<\/span><\/iframe><\/p>\r\n\r\n<p>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.<\/p>\r\n<p>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.<\/p>\r\n<h4>Example: Calculating P\/E Based on the Method of Comparables<\/h4>\r\n<p>The stock of a particular company is currently trading at $50. The company&#8217;s EPS as of the end of last year was $5. The average trailing P\/E for peer companies is $20. Is the company&#8217;s stock undervalued, fairly valued, or overvalued?<\/p>\r\n<h4>Solution<\/h4>\r\n<p>$$\\text{Trailing}\\ \\frac{\\text{P}}{\\text{E}}= \\frac{50}{5}=10$$<\/p>\r\n<p>Since the company&#8217;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<strong>.<\/strong><\/p>\r\n<p>Alternatively, using the average trailing P\/E for peer companies:<\/p>\r\n<p>$$\\text{Estimated value of the stock} = 5 \\times 20 = \\$100$$<\/p>\r\n<p>The company&#8217;s actual market price of $50 is lower than its intrinsic value of $100, implying that it is relatively undervalued.<\/p>\r\n<h4>Example: Calculating P\/E Based on the Forecasted Fundamentals<\/h4>\r\n<p>Consider the following information:<\/p>\r\n<ul>\r\n\t<li>Current stock price = $30 per share.<\/li>\r\n\t<li>Next year\u2019s expected EPS = $5<\/li>\r\n\t<li>Dividend payout ratio = 25%<\/li>\r\n\t<li>Required rate of return on equity = 10%<\/li>\r\n\t<li>Long-term growth rate = 4%<\/li>\r\n<\/ul>\r\n<p>Determine the stock&#8217;s leading P\/E multiple based on its fundamental value using the Gordon growth model.<\/p>\r\n<h4>Solution<\/h4>\r\n<p>$$\\begin{align*}\\text{Stock\u2019s actual}\\ \\frac{\\text{P}}{\\text{E}}&amp;= \\frac{30}{5}\\\\&amp;=6\\\\ \\\\<br \/>\r\n\\text{Next year\u2019s expected dividend} &amp;= 5 \\times0.25 \\\\&amp;=1.25\\\\ \\\\ \\text{Intrinsic value} &amp;=\\frac{\\text{D}_1}{(\\text{r}-\\text{g})}\\\\&amp;= \\frac{1.25}{(0.10-0.04)} \\\\&amp;=\\$20.83\\\\ \\\\<br \/>\r\n\\text{Leading}\\ \\frac{\\text{P}}{\\text{E}}\\ \\text{ratio}&amp;=\\frac{20.83}{5} \\\\&amp;= 4.17\\end{align*}$$<\/p>\r\n<p>The stock&#8217;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.<\/p>\r\n<blockquote>\r\n<h2>Question<\/h2>\r\n<p>Given the information below:<\/p>\r\n<ul>\r\n\t<li>Current stock price = $28.00<\/li>\r\n\t<li>Most recent EPS = $2.40<\/li>\r\n\t<li>Forecasted EPS = $3.20<\/li>\r\n\t<li>Growth rate = 3%<\/li>\r\n<\/ul>\r\n<p>The trailing P\/E ratio is <em>closest to:<\/em><\/p>\r\n<ol style=\"list-style-type: upper-alpha;\">\r\n\t<li>75.<\/li>\r\n\t<li>67.<\/li>\r\n\t<li>25.<\/li>\r\n<\/ol>\r\n<h3><strong>Solution<\/strong><\/h3>\r\n<p><strong>The correct answer is B.<\/strong><\/p>\r\n<p>$$\\text{Trailing}\\ \\frac{\\text{P}}{\\text{E}}= \\frac{28.00}{2.40}=11.67$$<\/p>\r\n<\/blockquote>\r\n<p>Reading 25: Market-Based Valuation: Price and Enterprise Value Multiples<\/p>\r\n<p><em>LOS 25 (b) Calculate and interpret a justified price multiple.<\/em><\/p>\r\n","protected":false},"excerpt":{"rendered":"<p>\ufeff\ufeff 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&#8230;<\/p>\n","protected":false},"author":5,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[102,401],"tags":[476,216,402,474],"class_list":["post-19844","post","type-post","status-publish","format-standard","hentry","category-cfa-level-2","category-equity-valuation","tag-calculating-a-justified-price-multiple","tag-cfa-level-2","tag-equity-valuation","tag-reading-29-market-based-valuation","blog-post","no-post-thumbnail","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v26.9 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Calculating a Justified Price Multiple - CFA, FRM, and Actuarial Exams Study Notes<\/title>\n<meta name=\"description\" content=\"Learn how to calculate and interpret justified price-to-earnings (P\/E) ratios based on methods like comparables and forecasted fundamentals.\" \/>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/calculating-a-justified-price-multiple\/\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"Calculating a Justified Price Multiple - 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