Justified Price to Earnings Ratio: Definition, Formula, Pros & Cons

KEY TAKEAWAYS

• The justified price-to-earnings ratio is a financial ratio that is used by applying the Gordon Growth Model.
• The justified P/E ratio is used in an effort to get a better understanding of a company’s underlying performance. 
• The GGM operates by employing the needed rate of return to discount an infinite number of dividends per share back into the present.
• It is a different application of the dividend discount model (DDM).
• Given its premise of constant dividend growth, the GGM is perfect for businesses with consistent growth rates.

What Is the Justified Price to Earnings Ratio?

The justified price-to-earnings ratio is the price-to-earnings ratio that the Gordon Growth Model “justifies.” 

The growth rate and cost of equity are only two examples of the fundamental variables included in this popular P/E ratio. Market analysts and investors regularly employ this variant of the conventional P/E statistic, which is frequently abbreviated to justified P/E ratio or simply justified P/E.

What Is the Formula for Calculating Justified P/E Ratio?

The formula used for calculating the justified P/E ratio is as follows:

continue to grow over time. The fair market value of a stock is determined using the GGM. When calculating the justified price-to-earnings ratio, we use the price obtained from the GGM to determine the justified P/E.

To calculate the GMM, you can use the below formula:

What Does Justified P/E Ratio Indicate?

Many market experts view a justifiable P/E ratio that is nearly comparable to the firm’s forward P/E ratio as proof that the company’s stock is properly valued, taking into account past price movements, the cost of equity, and the company’s predicted current and future growth rates.

The stock is most likely undervalued or underpriced if the justified P/E is higher than the forward P/E. Alternatively, if all other factors are equal and the justified P/E is lower than the firm’s projected P/E, the stock is regarded as being overvalued at the current price.

What Are the Advantages and Disadvantages of a Justified P/E Ratio?

The justified P/E ratio’s greatest benefit is that it demonstrates how the P/E is connected to the company’s fundamentals. It provides information on the anticipated dividend payout ratio, the necessary rate of return, and the anticipated dividend growth rate.

Its vulnerability to inputs, like the Gordon Growth model, is one of its drawbacks. As a result, analysts will typically calculate a range of values for various inputs in practice.

Example of Calculating a Justified P/E Ratio

Let’s say that Company X has a net income of $1,860,000. 

The number of shares that are trading are 1,000,000 at a price of $30 each. The earnings per share are $1.86 and the dividends per share sit at 0.80.

This would give a price-to-earnings ratio of 16.13. 

Now, with this information, we can figure out the justified price-to-earnings ratio. 

The cost of equity of Company X is 8%, with a forward growth rate of 5.4%. Using all of this information and inputting it into the above formula would give us a justified price-to-earnings ratio of 17.44. This would mean that the share price of Company X is currently underpriced. 

Summary

The Gordon Growth Model-related price-to-earnings ratio has a variant called the Justified P/E Ratio (GGM).

Connecting the conventional P/E ratio to the Gordon Growth Model yields the justified price-to-earnings ratio (GGM).

The P/E ratio evaluates a company’s common stock shares at their current market value in relation to its earnings. By using the justified P/E, you can learn more about a company’s true performance.