From forecasted fundamentals, work out a stock's justified price-to-earnings (P/E), price-to-book (P/B) and price-to-sales (P/S) ratios and explain them
The idea
Justified multiples based on forecasted fundamentals come from the constant-growth model. Leading P/E equals (D1 ÷ E1) ÷ (r − g). P/B equals (ROE − g) ÷ (r − g), reflecting the fact that expected returns above the cost of equity create a premium to book value. P/S equals (E0 ÷ S0) × (1 − b) × (1 + g) ÷ (r − g), the profit margin times the justified trailing P/E. In each case growth is usually estimated as retention ratio times ROE. The analyst compares each justified multiple with the market multiple. Traps include using a leading formula with trailing inputs, leaving out the 1 + g in trailing multiples, and using a growth rate inconsistent with the ROE and payout assumed.
In the app: 2 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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