Trailing p e ratio

What Is Trailing P/E Ratio?

The trailing price-to-earnings (P/E) ratio is a widely used financial metric that compares a company's current share price to its earnings per share (EPS) over the most recent 12-month period. It is a key component of equity valuation within financial ratios and investment analysis, offering a backward-looking view of how much investors are willing to pay for each dollar of a company's past earnings. This ratio is central to fundamental analysis, helping investors assess a company's profitability and market perception.

History and Origin

The concept of relating a company's stock price to its earnings has been a cornerstone of valuation for many decades, evolving as financial markets matured. Early forms of valuation often involved informal comparisons of a company's price to its generated profits. The formalization of the price-to-earnings ratio as a standard metric gained prominence with the rise of modern financial analysis. Academic research and notable financial thinkers have contributed to its widespread adoption and understanding. For instance, economists like Robert Shiller have extensively documented historical P/E ratio trends, highlighting their significance in market valuation. Over time, the trailing P/E ratio became a standard for assessing the relative expensiveness or cheapness of a stock based on its proven earning power.

Key Takeaways

• The trailing P/E ratio uses a company's actual earnings from the past 12 months.
• It serves as a common metric for valuing companies and comparing them within their industry or against broader market averages.
• A higher trailing P/E ratio often suggests that investors expect higher future growth or perceive the company as having lower risk.
• Conversely, a lower trailing P/E ratio might indicate that a company is undervalued or that investors anticipate slower future growth or higher risk.
• It is just one of many valuation tools and should be used in conjunction with other metrics.

Formula and Calculation

The formula for the trailing P/E ratio is straightforward:

Where:

• Current Share Price: The prevailing market price of one share of the company's stock.
• Trailing 12-Month Earnings Per Share (EPS): The total earnings generated by the company over the most recent four fiscal quarters, divided by the number of outstanding common shares. This figure is typically derived from the company's income statement.

Interpreting the Trailing P/E Ratio

Interpreting the trailing P/E ratio requires context. A high trailing P/E ratio might suggest that a company is a growth stock with strong future earnings potential, leading investors to pay a premium for its shares. Conversely, a low trailing P/E ratio could indicate a value investing opportunity, where the market may be undervaluing the company, or it could signal concerns about its future profitability.⁵ It is crucial to compare a company's trailing P/E ratio to those of its industry peers, the broader market, and its own historical P/E range to gain meaningful insights. For instance, technology companies often exhibit higher P/E ratios than mature industrial companies, reflecting differing growth expectations.

Hypothetical Example

Consider "Tech Innovations Inc." with a current share price of $150. Over the past 12 months, the company reported total earnings per share (EPS) of $5.

To calculate Tech Innovations Inc.'s trailing P/E ratio:

This means investors are currently willing to pay $30 for every $1 of Tech Innovations Inc.'s past earnings. If a competitor in the same industry had a trailing P/E of 20, it might suggest that investors have higher growth expectations for Tech Innovations Inc., or that the competitor is relatively less expensive based on its historical earnings.

Practical Applications

The trailing P/E ratio is a fundamental tool used across various aspects of finance:

• Stock Screening: Investors often use the trailing P/E ratio as a filter to identify potential investments, looking for companies that are either "expensive" (high P/E) or "cheap" (low P/E) relative to their earnings.
• Company Comparison: It provides a standardized way to compare the valuation of different companies within the same industry sector.
• Market Analysis: Analysts use the aggregate trailing P/E ratio of market indices, such as the S&P 500, to gauge the overall market sentiment and valuation levels.
• Mergers and Acquisitions (M&A): In M&A deals, the trailing P/E of target companies often plays a role in determining acquisition prices.
• Investment Research: Firms like Morningstar regularly publish and analyze trailing P/E ratios for individual stocks and funds, offering insights into their relative valuations.⁴

Limitations and Criticisms

Despite its widespread use, the trailing P/E ratio has several limitations:

• Backward-Looking Nature: It relies on historical earnings, which may not be indicative of future performance, especially for companies in rapidly changing industries or those undergoing significant business transformations.
• Earnings Volatility: Earnings can be highly volatile, particularly for companies in high-growth sectors or those with irregular revenue streams. This volatility can lead to extreme or even non-existent P/E ratios (in cases of negative profitability), making comparisons difficult and potentially misleading.³
• Accounting Practices: Differences in accounting principles and the use of non-GAAP (Generally Accepted Accounting Principles) earnings can skew the ratio, making it challenging to compare companies accurately.² Companies might also manipulate reported earnings, which affects the reliability of the ratio.
• Ignores Debt and Growth: The trailing P/E ratio does not directly account for a company's debt levels or the quality of its earnings, nor does it explicitly factor in future growth rates. Some critics argue that the P/E ratio itself may not be a good measure of value, suggesting that factors like return on invested capital are more correlated with long-term valuations than earnings growth.¹
• Negative Earnings: The ratio becomes meaningless when a company has negative earnings (a loss), as dividing by a negative number results in a negative P/E or "not applicable."

Trailing P/E Ratio vs. Forward P/E Ratio

The primary distinction between the trailing P/E ratio and the forward P/E ratio lies in the earnings data used for their calculation. The trailing P/E ratio uses a company's actual, reported earnings from the past 12 months. This makes it based on verifiable historical data, offering a clear, quantifiable measure of past performance.

In contrast, the forward P/E ratio utilizes analysts' estimates of a company's earnings over the next 12 months. This makes it a forward-looking metric that reflects market expectations and future growth prospects. While the trailing P/E provides a snapshot of historical valuation, the forward P/E offers insights into anticipated performance. Investors often use both metrics to get a comprehensive view: the trailing P/E to understand the current valuation relative to proven earnings, and the forward P/E to assess how much the market expects future earnings to grow.

FAQs

How is the trailing P/E ratio different from the P/E ratio mentioned generally?

When people refer to the "P/E ratio" without specifying, they typically mean the trailing P/E ratio, as it uses actual, historical earnings per share which are readily available and verified. The trailing P/E is the standard, backward-looking measure.

Can a company have a negative trailing P/E ratio?

Yes, if a company reports negative earnings (a loss) over the trailing 12-month period, its trailing P/E ratio will be negative or undefined, often expressed as "N/A" (not applicable). In such cases, the ratio is not meaningful for valuation purposes.

Is a high or low trailing P/E ratio better?

Neither is inherently "better." A high trailing P/E often indicates that investors anticipate significant future growth, making the company a growth stock. A low trailing P/E might suggest that the company is undervalued or has limited growth prospects, potentially appealing to value investing strategies. The "best" P/E depends on the industry, the company's business model, and an investor's strategy.

What industries typically have high trailing P/E ratios?

Industries characterized by high growth potential, innovation, and often lower current profitability due to reinvestment, such as technology, biotechnology, and some consumer discretionary sectors, frequently exhibit higher trailing P/E ratios.