How do you calculate the justified P/E ratio from the Gordon Growth Model, and when would you use trailing vs. leading P/E?

The justified P/E is one of the most elegant connections in CFA equity valuation -- it links the price multiple directly to the company's fundamentals rather than just observing what the market happens to be paying.

Derivation from the Gordon Growth Model

Start with: P0 = D1 / (r - g)

Since D1 = E1 x (1 - b), where b is the retention ratio:

P0 = E1 x (1 - b) / (r - g)

Leading (Forward) Justified P/E:

P0 / E1 = (1 - b) / (r - g)

Trailing Justified P/E:

Since E1 = E0 x (1 + g):

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

Worked Example: Meridian Software Corp (fictional)

Leading justified P/E = 0.40 / (0.11 - 0.06) = 0.40 / 0.05 = 8.0x

Trailing justified P/E = 0.40 x 1.06 / (0.11 - 0.06) = 0.424 / 0.05 = 8.48x

Justified price = 8.0 x E1 = 8.0 x ($3.20 x 1.06) = 8.0 x $3.39 = $27.14

Or equivalently: 8.48 x $3.20 = $27.14 (same answer either way)

Trailing vs. Leading -- When to Use Each

The Power of Justified P/E

If Meridian's actual market P/E is 12x but the justified P/E is only 8x, the stock appears overvalued -- the market is paying more than fundamentals warrant. Conversely, a market P/E of 6x against a justified 8x signals undervaluation.

Sensitivity Analysis: The justified P/E is extremely sensitive to the spread (r - g). If g increases from 6% to 7% while r stays at 11%, the leading P/E jumps from 8.0x to 10.0x -- a 25% increase from just a 1% change in growth. This is why small changes in growth assumptions can dramatically swing valuations.

For more on multiples-based valuation, explore our CFA Level II equity materials.