Page 24 - FINAL CFA II SLIDES JUNE 2019 DAY 7

LOS 29.f: Calculate and interpret the justified leading READING 29: DISCOUNTED DIVIDEND VALUATION
and trailing P/Es using the Gordon growth model.

MODULE 29.2: GORDON GROWTH MODEL
The price-to-earnings (P/E) ratio is most commonly used relative valuation indicator. An analyst
derives a justified P/E based on the firm’s fundamentals – 2 types:

• Leading P/E: based on the earnings forecast for the next period, and
• Trailing P/E: based on the earnings for the previous period.

where:
P = fundamental value
0
D = dividends just paid
0
D = dividends expected to be received in one year NOTE: The notation is tricky here. Because these are justified P/E ratios, the
1
E = current earnings “price” in the numerator is actually the fundamental value of the stock derived from
0
E = earnings expected in one year the Gordon growth model. It would be more accurate to label these ratios V / E 0
0
1
b = retention ratio and V / E , but the common convention is to call them “justified P/Es.”
1
0
(1 − b) = dividend payout ratio
g = dividend growth rate
EXAMPLE: Calculating justified leading and trailing P/E: Alliance, Inc., is currently selling for $16.00 on current earnings of $3.00 and a current dividend of $1.50.
Dividends are expected to grow at 3.5% per year indefinitely. The risk-free rate is 4%, the market equity risk premium is 6%, and Alliance’s beta is estimated to be 1.1.
Calculate the justified leading and trailing P/E ratios of Alliance, Inc.
NOTE:
If earnings are expected to grow,
E will be greater than E , and the
0
1
justified leading P/E (P / E ) will
1
0
be smaller than the justified
trailing P/E (P / E ) because
0
0
you’re dividing by a larger number
when you are calculating leading
P/E.
In fact, trailing P/E will be larger
than leading P/E by a factor of (1
+ g): justified trailing P/E =
justified leading P/E × (1 + g).