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'Justified' Stock Picks: Analyst's Toolkit

The price-to-earnings ratio is a key measure of value. But the so-called justified P/E ratio takes it a step further.

BOSTON (TheStreet) -- The price-to-earnings ratio is the most popular stock-valuation gauge because it's quick and easy to calculate as well as to compare with industry averages and competitors.

Without comparisons to other companies, the P/E ratio loses its helpfulness. A P/E ratio on its own is difficult to frame as good or bad. Calculating what's called the justified P/E ratio can help determine the multiple at which a stock should be trading based on fundamental factors, thereby adding more value to the trusty old P/E ratio.

Coming up with the justified P/E ratio requires a couple different tools, such as the

sustainable growth rate

and the

dividend discount model

. The justified P/E ratio is really just a rearrangement of the dividend discount model that produces a P/E ratio rather than price. The way to do that is to divide both sides of the equation by projected earnings.

The formula ends up looking like this: Price/Projected Earnings = (Future Dividends/Projected Earnings)/Required Return-Sustainable Growth

Most of those numbers are available on

TheStreet.com's

quote page, leaving the only unknown as the required return. This number can be calculated using the capital asset pricing model but backing out the implied required return in the stock market from the dividend discount model is the best bet to generate a reasonable estimate free of input bias.

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Applying this to

Wal-Mart

(WMT) - Get Report

, we can see that the stock market has assigned a required return of 16.6% on the retailer based on its projected 2011 dividend of $1.23, a sustainable growth rate of 14.2% and a share price of $53.18.

Using these figures, along with analysts' estimated earnings of $3.96 a share next year, Wal-Mart's justified P/E ratio comes in at 13.4, a hair under its current forward P/E ratio of 13.5. That would suggest that Wal-Mart is actually trading at a bit of a premium. This could be due to the jittery stock-market movements over the past few weeks, which has led investors to flee riskier holdings in favor of comfortable picks like Wal-Mart. As a result, the retail giant may have been bid up beyond its fair value.

The disconnect for Wal-Mart is only slight, so there's little actionable value to the difference. That's true for most large-cap stocks like Wal-Mart or

Microsoft

(MSFT) - Get Report

, which has a justified P/E of 12.7 and is trading at about that same multiple. Big names are usually accurately priced since trading volumes are high and so many investors are watching them like a hawk to exploit any mispricing.

Unless you plan on taking a contrarian view on big stocks based on different earnings expectations of required returns, the best bet for finding value is to look for holdings that are more unconventional and, therefore, more likely to be mispriced based on fundamental factors.

-- Reported by David MacDougall in Boston.

Prior to joining TheStreet.com Ratings, David MacDougall was an analyst at Cambridge Associates, an investment consulting firm, where he worked with private equity and venture capital funds. He graduated cum laude from Northeastern University with a bachelor's degree in finance and is a Level III CFA candidate.