Lots of investors and finance professionals use the PE ratio to assess whether a stock is good value or not, however lots of investors and finance professionals do not know how to assess a PE ratio in an absolute sense, and therefore only derive a benefit by comparing PE ratios among different companies. The justified PE ratio can be estimated using an adjusted version of the Gordon Growth Model. This can help investors assess whether or not a stock represents good absolute value as well as good relative value.
The Gordon Growth Model states that the justified share price of a stock can be calculated as:
Po is the justified share price at the present time
Do is the most recent dividend (full year dividend)
g is the sustainable dividend growth rate of the company
k is the cost of equity of the company
So if the company had a 10% cost of equity, a sustainable growth rate of 5%, and a dividend of $2 per share last year, the justified share price is calculated as:
2 x (1.05)/(0.1 - 0.05) = $42 per share.
We can get a justified PE ratio by ensuring that the Do is set to 1, or by dividing both sides of the equation by earnings:
So, if the company again has a cost of equity of 10%, a sustainable growth rate of 5%, a dividend of $2 per share last year and earnings of $3 per share last year, the justified PE ratio would be:
(2/3) x (1.05)/(0.1 - 0.05) = 14
Now we can cross check this. Previously we calculated using the Gordon Growth Model that the justified share price of the company was $42. We know from the last example that the earnings per share were $3 per share. 42/3 = 14, so both our equations agree with eachother.