Module 31.1 LOS 31.c: Leading and Trailing P/E ratio

The P/E ratio is the most widely used price multiple in the investment community.

There are reasons why it is so widely used:

  • Earnings power, as measured by earnings per share (EPS), is the primary determinant of investment value.
  • Empirical research shows that P/E differences are significantly related to long-run average stock returns.

Certain considerations must be made however, as the ratio has flaws as well:

  • Earnings can be negative, which produces a meaningless P/E ratio.
  • The volatile, transitory portion of earnings makes the interpretation of P/Es difficult for analysts.
  • Management discretion within allowed accounting practices can distort reported earnings, and thereby lessen the comparability of P/Es across firms.

The trailing P/E uses earnings from the 12 most recent months as its denominator.

                Trailing P/E = market price per share/EPS over last 12 months

The leading P/E uses a forecasted value for the next year’s earnings for its denominator.

                Leading P/E = market price per share/forecasted EPS for next 12 months

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