Trailing P/E Ratio

P/E Ratio based on the earnings of the immediately preceding 12 months

The Trailing PE Ratio is a valuation multiple used for valuing companies based on their past 12 months' actual earnings. It is a relative valuation multiple. It is calculated by dividing the current stock price by annualized earnings per share(EPS) for the past 12 months. 

It tells us at what multiple of the earnings the stock is trading. It is a measure of whether a company is overvalued or undervalued. It is always used with other valuation parameters while valuing a company. 

The trailing P/E is a value that an investor needs to pay for the $1 earning of a particular company. This ratio uses the performance of the latest four quarters of a company. Investors most widely use it, and it gives a more accurate measure of P/E value

The Price-To-Earnings ratio is a price or earnings multiple used to value a company based on its current market price and earnings per share. It is used for determining whether a company is overvalued or undervalued.

It is of two types: Forward P/E Ratio(projected basis) and Trailing P/E Ratio(backward-looking).

P/E Ratio = Market Value Per Share / Earnings Per Share.

EPS can be calculated by dividing a company's earnings by the total number of shares outstanding. EPS of a company is the earnings that can be distributed to shareholders in the form of dividends or bonuses. In addition, it can be reinvested in the business itself to meet the growing demand.    

P/E can be seen as the investor's analysis of a company's performance and how much an investor is willing to pay for $1 of the company's earnings.

According to the P/E ratio, if a company's earnings are expected to increase, its share price will also increase and vice versa.

P/E is never looked at as a standalone parameter for valuing a company. It is always used with other parameters. Although the average P/E for every industry is different, it is observed that finance sector companies usually have low P/E multiples.

Trailing And Forward P/E Ratio

The Trailing P/E Ratio relies on a company's past performance and is calculated by dividing the current market price of a share by the earnings per share of the past twelve months. It is usually more accurate as it uses a company's historical earnings that have already been reported. 

Like any other parameter, this too has its pros and cons; this is because past data of a company doesn't always depict the future performance. But, on the other hand, it is more reliable as predicted data may not be accurate.

Forward P/E Ratio, otherwise, is the estimated price-to-earnings as it uses analysts' predictions for the next twelve months earning data for a company. It shows what a company's earnings and valuation may look like after a year. 

The Forward P/E ratio may sometimes be misused to pump a company's stock price. This is because the analyst estimates are already available to the company before the results are declared. This sometimes may result in window-dressing or accounting fraud.

However, companies with a clean track record and ethical management often refrain from fraudulent activities.

Interpretation of P/E Ratio

P/E Ratio is the most widely used parameter to value a company. It shows whether a company is overvalued, undervalued, or correctly priced by the market. In addition, it is the measure of how much money an investor needs to pay for each dollar the company earns.

It helps to show us the market price of a stock relative to its earnings and how much people are willing to pay for that particular stock based on its past or future earnings.

A high P/E reflects that the particular stock is highly-priced compared to its earnings and shows that it may be overvalued.

A P/E of 15 shows that a person needs to invest $15 for every dollar that the company earns.

A low P/E ratio depicts that either the company is undervalued and might provide investors with above-average returns, or there is some negative reason why the market is valuing the company at dirt-cheap prices.

The reasons why investors do not value a company's stock highly are as follows :

  1. The company may be in a crowded industry where the competition is too high, and it cannot garner enough market share, due to which its margins are consistently low.
  2. The company may have a track record of unethical managerial activities such as - accounting fraud or involvement in unfair trade practices.
  3. The industry may not have a significantly bright future (also known as sunset industries). These are industries that usually cannot keep up with the changing dynamics of the market and therefore lose their customer base as a result.

Uses of P/E Ratio

  1. P/E is used to check a company's price bargain or expensiveness and reasons. A company may have a high P/E because of its financial, competitive, or future economic advantages or is highly priced. 
  2. Similarly, a company can have a low P/E because either it is available at a very good bargain or it may be because of its financial weaknesses.
  3. A disadvantage of the forward P/E ratio is that a company's earnings are also variable. The reported earnings could differ from the predicted earnings, and the stock prices are also highly unstable.Trailing P/E solves this problem to some extent as it considers earnings of the past four recent quarters, which are fixed and not variable. Hence, Trailing P/E becomes less volatile comparatively.
  4. Any investment is made to get good returns, so the P/E is used to determine the fair value of any investment.
  5. P/E is used to analyze a company's earnings easily.
  6. While using the P/E ratio for analysis, the cash holdings and debt of a company should not be ignored as a company's P/E is very responsive to changes in the cash and debt holdings of a company.

1. P/E v/s Earnings Yield

Earnings yield is the inverse of the P/E ratio and is not widely used in analyzing stock performance. It is defined as earnings per share divided by market price per share and is expressed in percentages. 

It becomes more critical when a person is interested in return on investment. At the same time, P/E shows the expensiveness of a stock relative to its earnings.

Earning's yield becomes more important if a company is a loss-making as for those companies, P/E is of less or no importance, and negative earning yield shows how much money that company is burning.

Comparisons Of P/E Ratio

2. P/E v/s PEG Ratio

Price-to-Earnings-to-Growth Ratio is a modified version of the P/E ratio. It shows a clearer picture of a company's performance by relating its price with earnings and growth in a specified period simultaneously.

Trailing or Forward P/E ratios cannot picture a company's stock performance with good accuracy. PEG ratio relates a company's earnings with earnings growth over a specified period.

PEG Ratio is calculated by dividing the market price of a stock by the trailing 12 months' earnings per share and earnings growth rate over the same period. The PEG ratio can also be calculated using trailing and future earnings and growth.

PEG Ratio = (P/E) / Earnings Growth

Suppose a company seems to be overvalued or undervalued using the PE ratio. In that case, adding the growth rate to it can show an additional dimension of the company's valuation to its investors.

Generally, a stock with a PEG ratio of less than 1 is considered undervalued because it shows that PE is much lower than its growth rate for that specific stock. On the other hand, a PEG ratio greater than 1 is considered overvalued.

Example: Consider a company with a P/E ratio of 15 and having an earnings growth rate of 10%; then, its PEG ratio will be - 15/10 = 1.5 (PEG Ratio = P/E % Growth rate).

From this data, it can be inferred that the company is slightly overvalued as its PEG ratio is greater than 1. However, it can also be said that the company has a low P/E compared to its earnings growth rate. 

3.- Absolute and Relative P/E

Absolute PE uses the current market price, and EPS can be calculated using the trailing 12 months' data (TTM) or the future projections. Absolute P/E can be defined as the P/E of the company as of today. 

For example, if a stock has a current market price of $100 and trailing twelve months' earnings per share of $5, its absolute PE will be:- ($100 / $5) = 20.

Relative PE compares the absolute P/E with historical P/E data of up to 10 years. It compares absolute PE with the highest or lowest PE in the past 10 years.

In addition, it also measures how close the current P/E is to the historical highs and lows.

Relative PE generally remains under 100%, whether compared with historical high or low, and it shows what percentage of the historic average P/E the current P/E is.

If the relative PE is more than 100%, the stock's PE has crossed a historic high and is trading at its highest PE.

Confines of P/E

PE has some very significant limitations that are:

  1. For companies that are not profitable and earnings per share are negative, calculating the P/E ratio will be a worthless task (as the denominator will always remain negative). So for loss-making companies defining P/E is challenging as it is often not interpretable.
  2. The absolute P/E can not be used for comparing companies of two different industries as their valuation parameters, growth rates, and earnings structure are different.
  3. P/E can only be used for comparing two companies of the same sectors as their growth pattern, earning structure, etc., will be similar. Comparing the P/E of firms from different industries will lead to improper analysis. 
  4. Checking the P/E of an individual company doesn't infer anything as it should ideally be compared against a benchmark number or with a company of the same industry. 

A company having a high P/E doesn't need to be overvalued. However, there may be a range of reasons as to why the company might be commanding premium valuations, and these could be :

  • The company could be a high-growth firm, and the investors are ready to purchase its stock at a premium.
  • The overall sector has a promising future outlook; as a result, the entire sector enjoys premium valuations from the market.
  • High P/E could sometimes result from a drastic price movement (towards the upside). Such sudden moves usually do not sustain as price retraces back to normality.

P/E - Standard Range!

Standard P/E can differ between various industries or companies. For example, some industries command higher P/Es compared to others because of their operating pattern and future scope.

Companies of the same industry also share widely variable PE for various reasons like market share, profitability margins, competitive edge, etc. Therefore, it is worth comparing companies in the same industry as they have significant similarities.

An industry can have an average P/E of as low as 10, and it may be as high as 50 or 60; it purely depends upon the industry structure.

A company with a low P/E usually seems appealing because of its availability at a great bargain. Still, it is important to check that a company could have been trading at a low P/E because of specific reasons such as:

  1. The decline in profitability margins of the business
  2. A significant change in the business or revenue model of the company 
  3. Dull future scope of the firm or industry
  4. Unfavorable macroeconomic situations 

Practical Application

Example 1

A company has a current market price of $100, and its trailing twelve months(last four quarters) earnings per share are $5. The trailing P/E of this company can be calculated as:

            P/E = $100 / $5

            P/E = 20.

This means that this stock is trading at 20 times its recent fiscal year earnings.

As the stock prices are volatile, if the price k falls to $90, its P/E will change accordingly to 18($90 / $5 = 18).

Example 2

Consider a company, ABC ltd., with a current stock price of $20/share and trailing twelve months' earnings per share of $3.50. Assume the industry P/E of ABC ltd. to be 5. 

Consider another company in the same industry, XYZ ltd., with a market price of $170/share and trailing twelve months' earnings per share of $40.

This example will apply the P/E ratio to compare two companies' valuations in the same industry against a benchmark ratio.

For company ABC ltd. P/E will be :- $20 / $3.50 = 5.71

For company XYZ ltd. P/E will be :- $170 / $40 = 4.25

By looking at the P/E ratios of both companies, we can say that company ABC ltd. is slightly overvalued. Its P/E is higher than the industry benchmark of 5, while company XYZ ltd. is undervalued as its P/E is lower than the industry benchmark.

However, as explained in the article, a high or low P/E can have various reasons and does not necessarily indicate the company's actual value.

Key Takeaways

  • The trailing P/E Ratio is a valuation parameter used by many investors, analysts, and corporate professionals to value a stock based on its current market price and earnings for the recent four quarters.
  • There are two types of P/E ratios: trailing and forward P/E ratios. The Forward P/E ratio is forecasted and is based on a company's projected earnings. It is used to foresee the possibility of a company's valuation in the near future.
  • The P/E Ratio is used to identify whether a company is overvalued or undervalued after looking at its price and earnings and combining it with its financial prospects and future growth.
  • A company's performance is an essential factor in judging whether a company is overvalued or undervalued.
  • The trailing P/E Ratio has a slight advantage over the forwarding P/E ratio because the latter considers the projected earnings of a company which can completely differ from the numbers reported by the company and thus give a wrong interpretation.
  • Many other valuation parameters are also used in place of the P/E Ratio as they rectify the limitations of the P/E Ratio. The PEG ratio is the appreciated version of the PE ratio. It also includes the earnings growth rate of a company which gives a more clear picture of the valuation of the company.
  • Earnings yield is also one parameter used for companies with a negative pe ratio to identify their burn rate.
  • Disadvantages of pe ratio include its failure in use for loss-making companies. P/E Ratio is also not a valuation parameter that can be used solely. It can't be used for two companies of different industries.
  • There is no standard value of the pe ratio. It is highly dependent on a company's business model, margins, and future scope.
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Researched and authored by Kavya Sharma | LinkedIn

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