**Overview:** Many investors in the U.S. look at price-to-earnings (P/E) as their main valuation tool. It is quick to compute and allows comparison of a single stock to it's peer group or the market as a whole. The problem is: what is the right staring point for a P/E? What multiple should the stock market as a whole trade at? How big of a premium or discount should a given stock garner?

**Alternative Valuation Methods:** Other than P/E, there are a handful of other multiples that can be analyzed. Price/Book, EV/EBITDA, Price/Sales, etc. My criticisms of the P/E metric apply to the other multiples as well: What is the right level for the metric? How much does the macro environment change the base multiple? How much of a premium or discount does a given stock deserve?

These issues can all be addressed in great detail by building a discounted cash flow model. This is when an analyst forecasts sales, earnings, and cash flows into the future based on reasonable expectations; sets an appropriate discount rate to reflect the macro environment; and discounts the cash flows back to get a net present value. The weakness with discounted cash flow models is that they are very detailed. It's hard to look at any volume of companies given the time needed to build a good forecast. So what is a reasonable solution?

**Justified P/E Ratio:** The Justified P/E Ratio is a formula that uses macro inputs like the discounted cash flow model, but is simple enough to use to analyze a broad group of companies. It avoids the weaknesses of standard multiple valuation tools by calculating an appropriate or 'justified' P/E ratio. The formula is below:

P |
= | Plowback x (1 + Growth) |
|||

E |
(Cost of Equity - Growth Rate) |

As you can see, the formula takes into account a forecasted growth rate, cost of equity, and dividend policy to get a "justified" P/E level. Let's dig in to the parts!

**Plowback:** The amount of earnings that aren't paid out as dividends. The more a company retains, the more growth can be sustained and realized.

**Growth:** A forecast for the level of growth a company can sustain.

**Cost of Equity:** Using CAPM, this takes into account the current interest rate environment and a company's riskiness as measured by Beta.

**Putting it into Practice:** Let's look at the S&P 500 (NYSEARCA:SPY) and see what the P/E ratio should be. The growth cannot exceed GDP over the long-run, so let's apply GDP as the growth rate. My GDP forecast is 3.6%.The current earnings forecast for the S&P 500 is 118.47 with dividends of 43.14, per Bloomberg. Thus, the plowback is 63.9%. CAPM gives a cost of equity of 8.33% with today's 2.33% 10-year yield and a 6.0% equity risk premium. Put this into the formula and the Justified P/E is 14.0x. So 14.0 x 118.47 = 1,658.09.

The market closed at 2,114.07 recently. So the market is over-valued by about 22%, according to the formula.

The strength of the model is that we can evaluate what happens when interest rates change. The chart below shows what happens to the Justified P/E and S&P Targets as interest rise and fall.

-100bps | -50bps | Today | +50bps | +100bps | |

10-Year Yield | 1.33% | 1.83% | 2.33% | 2.83% | 3.33% |

Cost of Equity | 7.33% | 7.83% | 8.33% | 8.83% | 9.33% |

Justified P/E | 17.8x | 15.7x | 14.0x | 12.7x | 11.5x |

S&P Target | 2,102.62 | 1,854.08 | 1,658.09 | 1,499.57 | 1,368.72 |

Upside/Downside | -0.5% | -12.3% | -21.6% | -29.1% | -35.3% |

Next, let's explore changes to growth assumptions. If the growth rate increases, the Justified P/E will increase. See below:

-100bps | -50bps | Today | +50bps | +100bps | |

Growth Rate | 2.60% | 3.10% | 3.60% | 4.10% | 4.60% |

Cost of Equity | 8.33% | 8.33% | 8.33% | 8.33% | 8.33% |

Justified P/E | 11.4x | 12.6x | 14.0x | 15.7x | 17.9x |

S&P Target | 1,355.51 | 1,492.33 | 1,658.09 | 1,863.03 | 2,122.91 |

Upside/Downside | -35.9% | -29.4% | -21.6% | -11.9% | 0.4% |

**It looks like the market is pricing in higher growth today than I'm assuming in the base case.**

**Model Weaknesses:** The biggest weakness of the model is that a 100% payout ratio leads to a 0.0x P/E. It makes intuitive sense that this is true. If a company isn't reinvesting in their business, how can earnings be sustained or grown? Very few companies can pay out huge percentages of income while still growing earnings. Tobacco companies can. Strong brands can - people will continue to buy Coca-Cola or Kraft Macaroni & Cheese without changes, improvements, or advertisements. Also, REITs and companies that own real assets can pay out big portions of earnings while sustaining growth because their assets generally increase in value over time, regardless of reinvestment given the monopoly-like nature of real assets.

Another major weakness is the reliance on CAPM in setting the cost of equity. It's very difficult to estimate the equity risk premium and how it changes over time. My studies suggest a range of 4-8% is fairly typical, though pinpointing the correct level is difficult. I tend to assume 6.0% in most market conditions as it is in the middle of the range and determining when to use another value is difficult in real-time. The "gut-test" is important here. Does an 8.33% cost of equity (and long-term expected return) feel reasonable? It does to me, given the long-term returns of the stock market are in the 7-12% range.

**Stock Example:** Let's look at Apple (NASDAQ:AAPL) and figure out where it should trade on a Justified P/E basis. AAPL is expected to earn $9.01 this year and pay out $2.08 of dividends. I'll assume the same 3.6% growth, admitting the company is likely to exceed this rate. The beta is 1.07 so my CAPM cost of equity is 8.75%. Put it all together and my Justified P/E is 15.5. Thus, my AAPL target price is $139.66. Shares closed recently at $130.12, giving me 7.3% upside from the model.

But we've shown that the market is pricing in higher growth than 3.6% today, per the charts above. What would the value be if we put the market's implied ~4.60% growth into the AAPL model? Changing no other assumptions, the Justified P/E would be 19.4x - giving a target value of $174.79, 34.3% upside from the model.

**Summary:** The Justified P/E is superior to regular multiple valuation tools because it allows an analyst to take macro conditions and growth estimates into account to calculate an appropriate level for the P/E. It allows one to fairly quickly look at multiple companies, which is a weakness of the more detailed discounted cash flow valuation tool. It is my go-to tool for valuing stocks. The weaknesses of the model somewhat limit its utility in evaluating a few sectors and types of high payout companies, but overall is a valuable tool for stock analysts.

**Disclosure:** The author is long AAPL.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.