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Subject 3. Price to Earnings: Valuation Based on Forecasted Fundamentals PDF Download
From the Gordon growth model:

P0 = D1 / (r - g)

If we divide this expression by last 12 months' earnings, we get the formula for the trailing P/E multiple:

P0 / E0 = D0 (1 + g) / [E0 (r - g)] = (1 - b) (1 + g) / (r - g)

where b is the earnings retention rate, and 1- b is the dividend payout ratio.

We can also compute the leading P/E multiple by dividing both sides of the Gordon equation by the forecasted value of next 12 months' earnings:

P0 / E1 = D1 / [E1(r - g)] = (1 - b) / (r - g)

Implications:

  • P/E is positively related to dividend growth rate, all else equal.
  • P/E is inversely related to required return, all else equal.

Example

  • Payout ratio = 40%.
  • Equity required return = 12%.
  • Expected dividend growth rate = 4%.

Calculate the trailing and leading P/E multiple based on these forecasted fundamentals.

Trailing P/E = P0/E0 = (0.40 x 1.04) / (0.12 - 0.04) = 5.2.
Leading P/E = P0/E1 = 0.40 / (0.12 - 0.04) = 5.0.

Predicted P/E from regression.

Regressing P/E multiples of a population of stocks on the fundamental components of the Gordon model gives us a simple formula for a justified P/E multiple given the fundamentals for a specific stock. Instead of using the required rate of return as one of the independent variables, analysts usually employ the associated risk measure, beta, which can be readily calculated from available price variation history.

Example

  • Dividend payout ratio = 0.40
  • Beta = 0.60
  • Expected earnings growth rate of 3%.
  • A regression on other public utilities produces the following equation:
    Predicted P/E = 5 + (6 x dividend payout) + (10 x growth) - (0.5 x beta)

Calculate the predicted P/E.

Predicted P/E = 5 + (6 x 0.4) + (10 x 0.03) - (0.50 x 0.6) = 7.4.

Analysts should watch out for:

  • changing relationships.
  • multicollinearity.
  • unknown predictive power.

Learning Outcome Statements

calculate and interpret alternative price multiples and dividend yield;

calculate and interpret underlying earnings, explain methods of normalizing earnings per share (EPS), and calculate normalized EPS;

explain and justify the use of earnings yield (E/P);

describe fundamental factors that influence alternative price multiples and dividend yield;

calculate and interpret the justified price-to-earnings ratio (P/E), price-to-book ratio (P/B), and price-to-sales ratio (P/S) for a stock, based on forecasted fundamentals;

calculate and interpret a predicted P/E, given a cross-sectional regression on fundamentals, and explain limitations to the cross-sectional regression methodology;

evaluate a stock by the method of comparables and explain the importance of fundamentals in using the method of comparables;

calculate and interpret the P/E-to-growth ratio (PEG) and explain its use in relative valuation;

calculate and explain the use of price multiples in determining terminal value in a multistage discounted cash flow (DCF) model;

explain alternative definitions of cash flow used in price and enterprise value (EV) multiples and describe limitations of each definition;

calculate and interpret EV multiples and evaluate the use of EV/EBITDA;

CFA® 2023 Level II Curriculum, Volume 4, Module 25

User Contributed Comments 3

User Comment
gnacinka using regression seems crazy in this context, the formula is not linear under any circumstances, is multiplicative, not additive!
perator Why is the trailing P/E numerator multiplied by 1.04? Shouldn't that be for Leading P/E?
merc5559 @perator- Think of it like this: Leading P/E is Po/E1 making earnings leading. No adjustment needed. To make earnings trailing in the trailing P/E formula you must adjust by (1+g) to get P1. This gives you P1/Eo
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I am happy to say that I passed! Your study notes certainly helped prepare me for what was the most difficult exam I had ever taken.
Andrea Schildbach

Andrea Schildbach

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