While it feels way too complicated to a majority, determining a target P/E multiple for a stock isn't any rocket science. Using a simple formula and some basic judgment gets you most of the way there, though remember that valuation is an art, not a science, so your approach can differ.
The Gordon Growth Formula determines a target P/E ratio for a constant, sustainable growth model: P/E = Payout Ratio ÷ (R − G), where the payout ratio is dividend per share divided by earnings per share, R is the cost of equity, and G is the sustainable growth rate.
For companies with strong cash flow generation, such as fertilizers or autos, a 100% payout ratio is a reasonable assumption, otherwise they'd be reinvesting in growth instead.
Estimating the Cost of Equity
Cost of equity can be calculated a few ways; a common approach is risk-free bond yield plus a risk premium. The equity risk premium is the additional return an investor requires to take on the added risk of equities, 10% is a reasonable starting point, though this can vary with your risk profile.
For the risk-free yield, you can either look at long-term yields to avoid short-term fluctuations, or use short-term benchmarks to keep current monetary policy in mind. With the 10-year PIB yield hovering around 14% and the 12-month T-Bill around 18%, a conservative approach uses 18% + 10% = 28% as the cost of equity (R).
Estimating the Growth Rate
For growth rate (G), nominal GDP growth is a reasonable benchmark: 10% inflation + 2.5% real GDP growth = 12.5% earnings growth. That gives us: Target P/E = 1 ÷ (28.0% − 12.5%) = 6.5x, a benchmark multiple for sound, cash-flow generating companies.
Adjusting for Special Cases
Two considerations may require additional work. First, above or below short-term earnings growth: if a company is likely to experience supernormal growth for the next 2–3 years, apply the 6.5x multiple to fourth-year earnings (once it enters a normal growth period) and discount it back using the cost of equity. Second, cash flow constraints: for companies unable to generate cash flows in line with their profitability, apply a discount depending on the severity of the problem, for example, a 50% discount for PSO.
Assigning a target P/E is the last step in your valuation process. Forming an earnings outlook is a much more critical and time-consuming exercise, one worth its own deep dive.