When it comes to analyzing and researching stocks, the price-to-earnings ratio is one of the most important financial ratios to quickly assess a company’s valuation and profitability. But the fact is that there are several different types of P/E ratios investors can use when analyzing stocks.
Today we’ll look at the trailing P/E ratio, how to calculate it and use it, and the advantages and disadvantages of analyzing stocks with it.
What is the trailing P/E ratio?
The trailing P/E ratio is a type of price-to-earnings ratio that is calculated based on the trailing twelve months (TTM) earnings of a company. While the regular price-to-earnings ratio of a stock might be calculated based on the earnings of the previous year, the trailing P/E ratio compares the company’s earnings over the last twelve months with the current stock price.
Trailing P/E ratio formula
To calculate the trailing price-to-earnings ratio, all you have to do is to take the current stock price and divide it by the EPS over the last 12 months. Here are a few variations of the trailing price-to-earnings ratio formula:
Trailing P/E ratio = Current Stock Price / TTM EPS or EPS over the last 12 months
Trailing P/E ratio = Current Market Capitalization / Total Earnings TTM
Trailing P/E example
Let’s consider XYZ stock, with a current stock price of $10 a share, whose earnings per share in the past 12 months have been $1.
To calculate the trailing price-to-earnings ratio, simply divide 10 by 1, and you get a trailing P/E ratio of 10.
Why you should use the trailing P/E ratio
Whenever you are analyzing a stock and comparing its earnings, it is crucial to have up-to-date data. You want to understand how the company is performing currently and not how it was a few months ago. For this reason, the trailing P/E ratio is usually the best price-to-earnings ratio you should use.
This is because instead of calculating P/E based on the last year's earnings, the trailing P/E ratio focuses on the earnings over the past 12 months, and this gives you a much clearer picture of the company’s earnings than using the last fiscal year's results.
However, there is one major shortcoming or limitation when it comes to using the trailing P/E ratio that you should be aware of.
The company’s earnings over the past 12 months may slightly skewed, either positively or negatively. If you consider a company with an amazing or terrible recent quarter, the earnings over the last 12 months will include these one-off quarterly results. For this reason, the earnings might not be accurately represented, and this is something that investors need to always consider.
When to use the trailing P/E ratio
Whenever you are analyzing a stock, you should always consider its trailing P/E ratio, but be aware of the company’s results and whether or not they have been influenced either positively or negatively.
Another great way of using the trailing P/E ratio is to compare it with the historical P/E ratio of the company. This allows investors to get a historical perspective on the company’s valuation solely based on its price-to-earnings over time.
While it is not a surefire way of identifying undervalued stocks, finding companies with a trailing P/E ratio under their historical average is a great way to find value stocks since the P/E ratio tends to revert to its historical average over time.
Trailing P/E ratio advantages
Here are the main advantages of using the trailing P/E ratio:
- Quick and easy way to analyze a stock’s valuation: The trailing price-to-earnings ratio gives you a glimpse into the company’s valuation relative to its earnings.
- Easily compare stocks: It also allows you to compare stocks across industries, and it will help you consider different stocks to pick.
- It shows you investor expectations: A stock with a higher trailing P/E ratio is a company investors expect to grow over the long term.
- Easily determine the stock’s quality: Higher quality companies will often have higher valuations, and therefore the higher the trailing P/E, the more desirable the stock will be.
Trailing P/E ratio disadvantages
While there are plenty of advantages to using the trailing price-to-earnings ratio, there are also a few cons that investors should be aware of:
- Can easily be misinterpreted: The trailing P/E ratio can give investors a wrong idea about a stock if its earnings have been volatile over the last 12 months.
- The trailing P/E ratio isn’t enough to analyze a stock: While it is a useful metric to compare the stock price with the earnings, investors shouldn’t base their decisions just on the trailing price-to-earnings ratio.
- It changes with expectations: Investor expectations drive the narrative in the stock market, and therefore valuations are affected by it. The trailing P/E ratio also fluctuates based on how expectations are perceived.
- It can be insufficient without considering the forward P/E ratio: When analyzing growth stocks, the trailing P/E ratio might be very high, but the forward P/E ratio might be lower; therefore, you should consider both.
Difference between trailing P/E ratio and forward P/E ratio
The trailing price-to-earnings ratio is based on the earnings over the last 12 months, while the forward P/E ratio focuses on the projected future earnings over the next 12 months.
Here is how you can calculate the forward price-to-earnings ratio:
Forward P/E Ratio = Current Stock Price / Expected EPS over the next 12 months
The trailing P/E ratio is a measure of the company’s profitability based on previous earnings, and it is useful when conducting valuation and gives a clear picture of the company’s current value. However, when it comes to analyzing stocks whose earnings are expected to increase, the forward price-to-earnings ratio might not be enough. For this reason, you also need to consider the forward P/E ratio.
The forward P/E ratio is mainly used when making projections and estimates about the stock’s valuation because it calculates the price-to-earnings ratio based on the expected earnings over the next 12 months.
In some cases, a forward P/E ratio might be a better solution to assess a company’s value. If, for instance, you are calculating the value of a high-growth stock, it might be better to use forward price-to-earnings. Because the current earnings might not give a full scope of what the earnings will be like in the near future. Therefore the forward P/E ratio is more useful when predicting the profitability and the company’s ability to generate earnings.
Is a high or low trailing P/E ratio better?
It is essential to understand that the trailing P/E ratio may trick investors into thinking a certain stock is overvalued or undervalued. For example, if a company has relatively stable earnings but over the last months it had an overperforming or underperforming quarter, that might affect its trailing P/E ratio.
For this reason, you always need to evaluate a high or low trailing P/E ratio based on the earnings of the last 4 quarters and whether or not they are in line with the company’s expected financial performance.
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