Fundamental P/E

The ordinary P/E ratio you see quoted is simply today's price divided by earnings — a market fact, not a judgement about what the stock is worth. Fundamental P/E is different. It is what the P/E ratio should be, worked out from the company's own dividend policy, growth prospects and the return investors require.

Because it is built from the same ingredients as the dividend discount model, fundamental P/E connects two valuation approaches that can otherwise look unrelated: relative valuation (multiples like P/E) and discounted cash flow valuation (models like the dividend discount model).

Section 3.5.4.4 derives fundamental P/E from the dividend discount model: P = D1 ÷ (k − g), where D1 is next year's expected dividend, k is the required rate of return, and g is the expected dividend growth rate. Since D1 can be written as E1 × DPR (next year's expected earnings per share times the dividend payout ratio), dividing both sides by E1 gives:

P ÷ E1 = DPR ÷ (k − g)

This ratio — the workbook calls it the "Fundamental P/E" of a company — is driven by exactly three variables: the required rate of return (k), the expected growth rate of dividends (g), and the dividend payout ratio (DPR). The workbook's own directional rules: a higher expected dividend growth rate raises the fundamental P/E; a higher required return lowers it; a higher dividend payout ratio raises it. Because the formula leans on the payout ratio, the workbook cautions it should be applied cautiously, and mainly to stable, dividend-paying companies — for a company with negative or negligible profit, the ordinary P/E ratio is not meaningful for valuation at all, and neither is the fundamental version built from it.

Illustrative figures, following the workbook's own formula. Shubham Consumer Products Ltd expects to pay a dividend payout ratio of 40%, has an expected dividend growth rate of 8% p.a., and its equity investors require a 14% return.

Fundamental P/E = DPR ÷ (k − g) = 0.40 ÷ (0.14 − 0.08) = 0.40 ÷ 0.06 = 6.67.

If the company's expected earnings per share next year (E1) is Rs 15, the fundamental value implied is: P = Fundamental P/E × E1 = 6.67 × 15 = Rs 100.05.

If the stock is actually trading at Rs 130 in the market — a market P/E of 130 ÷ 15 = 8.67, well above the fundamental 6.67 — the gap suggests the market is pricing in either a higher growth rate, a lower required return, or simply optimism beyond what the current payout and growth assumptions justify. A manager relying on fundamental P/E would flag the stock as expensive relative to its own dividend fundamentals, whatever the market multiple says.

Chapter 3 (Investing in Stocks), section 3.5.4.4 (Combining Relative Valuation and Discounting Models), derives fundamental P/E from the dividend discount model step by step and names the three driving variables. Expect a question computing fundamental P/E from DPR, k and g, and one on the direction each variable pushes the ratio.

• Higher required return (k) lowers fundamental P/E; higher growth (g) and higher payout (DPR) both raise it — k sits in the denominator with a negative sign in front of g, so the two act in opposite directions on the P/E.
• The formula uses forward earnings (E1), not trailing earnings — mixing this up with the ordinary trailing P/E changes the answer.
• Fundamental P/E works best for stable, dividend-paying companies — the workbook explicitly cautions against applying it broadly, and says it is not meaningful at all for a company without positive profit (PAT).
• This is a derived, model-based P/E, not the observed market P/E — a gap between the two is a valuation signal, not a calculation error.
• Do not confuse fundamental P/E with the PEG ratio (price/earnings to growth), a separate relative-valuation tool covered a few pages earlier in the same section, which relates P/E directly to the growth rate rather than deriving P/E from the dividend discount model.