Welcome to Wall Street Prep! Use code at checkout for 15% off.
Enrollment Extended for September Wharton & Wall Street PrepWSP Programs:
Private EquityReal Estate Investing
Hedge Fund InvestingFP&A
Wharton & Wall Street Prep Certificates:
Enrollment Extended for September Programs →

Justified P/E Ratio

Step-by-Step Understanding Justified P/E Ratio

Last Updated July 4, 2023

How to Calculate Justified P/E Ratio?

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.

Current Share Price (Po) = [Do * (1 + g)] / (k – g)

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.

Justified P/E Ratio = [(DPS / EPS) * (1 + g)] / (k – g)

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.

Justified P/E Ratio Calculator – Excel Template

We’ll now move to a modeling exercise, which you can access by filling out the form below.

By submitting this form, you consent to receive email from Wall Street Prep and agree to our terms of use and privacy policy.

Submitting...

1. Current Share Price Calculation Example

Suppose a company paid a dividend per share (DPS) of \$1.00 in the most recent reporting period.

• Dividend Per Share (Do) = \$1.00
• Sustainable Dividend Growth Rate = 2%

As for the rest of our model assumptions, the company’s cost of equity is 10% and the sustainable dividend growth rate is 2.0%

• Dividend Growth Rate (g) = 2%
• Cost of Equity (ke) = 10%

If we grow the current dividend by the growth rate assumption, the next year’s dividend is \$1.02.

• Next Year Dividend Per Share (D1) = \$1.00 * (1 + 2%) = \$1.02

Using those assumptions, the justified share price comes out as \$12.75.

• Current Share Price (Po) = \$1.02 /(10% – 2%) = \$12.75

2. Justified P/E Ratio Calculation Example

In the next part, we will calculate the justified P/E ratio.

However, we are missing one assumption, the reported earnings per share (EPS) of our company in the past year – which we’ll assume was \$2.00.

• Earnings Per Share (EPS) = \$2.00

But if we were to divide both sides by EPS, we can calculate the justified P/E ratio.

• Justified P/E Ratio = [(\$1.00 / \$2.00) * (1 + 2%)] / (10% – 2%) = 6.4x

In closing, we can cross-check the implied share price from the justified P/E and the current share price to ensure our calculation is correct.

After multiplying the justified P/E of 6.4x by the historical EPS of \$2.00, we calculate the implied current share price as \$12.75, which matches the Po from earlier.

• Implied Current Share Price (Po) = 6.4x * \$2.00 = \$12.75

Step-by-Step Online Course

Everything You Need To Master Financial Modeling

Enroll in The Premium Package: Learn Financial Statement Modeling, DCF, M&A, LBO and Comps. The same training program used at top investment banks.

Learn Financial Modeling Online

Everything you need to master financial and valuation modeling: 3-Statement Modeling, DCF, Comps, M&A and LBO.

The Wall Street Prep Quicklesson Series

7 Free Financial Modeling Lessons

Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts.