The Justified Ratio
Fundamental drivers are key to understand the valuation ratios
What is the just(ified) P/E ratio?
The price-to-earnings (P/E) ratio is the most commonly used (and maltreated) valuation metric in finance. While the trailing and forward P/E deserve much attention among investors, the justified P/E isn’t used as much.
Trailing and forward P/E ratios are analyzed through time-series (historical average) and cross-sectional (comps average) comparisons. Such analyses, however, reveal little about the firm’s intrinsic valuation when the firm itself or the industry it belongs to is overvalued. The justified P/E ratio provides an intrinsic benchmark, the valuation at which the firm should ideally trade, for a given set of fundamental drivers.
The prime determinants of a firm’s intrinsic value are:
The firm’s ability to generate cashflows
The volatility of cashflows
The growth in cashflows
Regardless of the valuation method chosen, these three factors shape the inputs needed to value the firm. All else equal, a firm with high cashflow yield, low risk, and high growth potential should trade at a higher valuation than a firm lacking these qualities. To understand the drivers of a P/E ratio, let us consider the simplest valuation framework, the dividend discount model, for a stable growth firm:
The ‘D’, ‘ke’, and ‘gn’ in the above equation refer to dividend per share, cost of equity, and earnings growth rate. Dividend can be expressed as payout ratio * EPS, since dividends are discretionary capital returns determined by the company’s payout policy.
Dividing both sides of the equation with expected earnings per share (E), while expressing payout ratio as dividend per share (DPS) divided by EPS, and further simplification leads us to the justified P/E ratio:
The above function will be of limited use if the firm doesn’t pay dividends or repurchase shares. Typically, high growth firms choose to reinvest their earnings rather than return capital to shareholders. An alternative form of justified PE ratio can be derived using ROE, which will be useful for evaluating firms that do not pay dividends. The justified PE ratio can be linked to the firm’s return on equity (ROE) using the following property: g = ROE * (1-payout ratio).
The numerator of the above equation represents a firm’s payout ratio, which is a function of the expected growth rate and return on equity (ROE). Hence, the P/E ratio is an increasing function of the payout ratio and growth rate and is inversely proportional to the firm's riskiness.
There is no ‘smoke’ without fire
To illustrate the justified P/E, consider Altria Group, Inc. ( MO 0.00%↑ ), one of the largest producers and marketers of tobacco products. Altria is a stable growth firm operating in a mature oligopolistic industry with few large-scale organized competitors. The firm’s high dividend payout ratio is characteristic of these features and indicates the priority of high capital return to shareholders.
Our analysis concerns the period from 1-Jan-24 to 31-Dec-24, during which Altria paid $3.96 in dividends per share (DPS). Based on the NTM EPS consensus of $5.35, the firm’s payout ratio is 74.0%. Assuming a cost of equity of 6.5% (based on 0.68 equity β) and an earnings growth rate of 4.5% based on consensus estimates results in 38.9x justified P/E ratio.
Comparing Altria’s justified P/E with its forward P/E of 9.9x indicates ample potential for valuation multiple expansion in the future. Altria’s implied ROE, based on its fundamentals, is 17.5%, which places it among the top 35% of the companies if the industry average ROE is representative of the underlying profitability of the constituent companies. Altria’s ROE will increase further if it grows at a higher rate or increases its payout ratio. Such potential for sustained growth is underscored by the fact that Altria had the maximum lifetime buy-and-hold return in a famous study conducted by Hank Bessembinder of Arizona State University.
To summarize…
The justified P/E ratio is a useful tool to assess the true worth of an equity stock. Underpinned by company fundamentals, the ratio can be used as an unbiased indicator of a company’s worth, especially during peaks and troughs of the valuation cycle. However, practitioners must realize that the justified PE ratio discussed in this article is best suited to value stable growth firms. While attempting to value companies that are either growing at suppressed or abnormal rates, a long-run stable growth must be estimated before using it as an input in the justified P/E ratio.