What is the Justified P/E Ratio?
The Justified P/E Ratio is a variation of the price-to-earnings ratio linked to the Gordon Growth Model (GGM) in an effort to better understand a company’s underlying performance.
How to Calculate Justified P/E Ratio (Step-by-Step)
The justified P/E ratio can be thought of as an adjusted variation of the traditional price-to-earnings ratio that aligns with the Gordon Growth Model (GGM).
The Gordon Growth Model (GGM) states that a company’s share price is a function of its next dividend payment divided by its cost of equity less the long-term sustainable dividend growth rate.
Where:
- Do = Current Dividend Per Share (DPS)
- g = Sustainable Dividend Growth Rate
- k = Cost of Equity
Moreover, if we divide both sides by the EPS – the current share price and the dividend per share (DPS) – we are left with the justified P/E ratio.
Justified P/E Ratio Formula
The formula to calculate the justified P/E ratio is as follows.
Note how the “(DPS / EPS)” component is the dividend payout ratio %.
Since the payout ratio is expressed in the form of a percentage, the GGM formula is effectively converted into the justified P/E ratio.
- Trailing: If the EPS used is the current period historical EPS, the justified P/E is on a “trailing” basis.
- Forward: If the EPS used is the forecasted EPS for a future period, the justified P/E is on a “forward” basis.
Learn More → Valuation Multiple
Core Value Drivers of the Justified P/E Ratio
The fundamental drivers that impact the justified P/E are the following:
1) Inverse Relationship with Cost of Equity
- Higher Cost of Equity → Lower P/E
- Lower Cost of Equity → Higher P/E
2) Direct Relationship with Dividend Growth Rate
- Higher Dividend Growth Rate → Higher P/E
- Lower Dividend Growth Rate → Lower P/E
3) Direct Relationship with Dividend Payout Ratio (%)
- Higher Payout Ratio % → Higher P/E
- Lower Payout Ratio % → Lower P/E
Therefore, the justified P/E ratio indicates that a company’s share price should rise from a lower cost of equity, higher dividend growth rate, and higher payout ratio.