The trailing price to earnings ratio – trailing P/E ratio – is the most commonly used of the P/E variations (trailing versus forward). The trailing P/E ratio accounts for a company’s actual earnings instead of its projected earnings. It is considered one of the most accurate ways of determining how valuable a company (or its stock) actually is; it offers – in a perfect market – a fair valuation of a stock.
The trailing P/E ratio is most commonly used because it offers the most accurate valuation of a company, using historical earnings in comparison to current prices.
Determining the P/E ratio is important for investors because it helps them get a better understanding of what they get for their investment; a good profit margin for a small price is a bargain.
The forward P/E ratio is less commonly used because it compares current prices to projected earnings in the future; the projected numbers can change or be adjusted to help the company look more attractive.
Formula for Trailing P/E Ratio
The trailing P/E ratio is calculated as follows:
Importance of Price to Earnings
Determining price to earnings is important specifically to investors because it shows what is actually being paid per dollar that a company logs in its bottom line. There is a clear bargain to be obtained if an investor can tap into profits for a fairly low price. If the cost is high in relation to earnings, an investor needs to ask the reason behind it.
As discussed above, the trailing P/E ratio provides the clearest insight into the actual value of a company and its stock because it uses historical earnings per share.
What is the Forward P/E Ratio?
The forward P/E ratio is different and somewhat less popular. The forward P/E ratio divides a stock’s current share price by future earnings. The formula is sometimes referred to as estimated price to earnings.
The forward P/E ratio offers a few benefits. It helps compare a company’s current earnings to those that it is on track to make in the future. Still, the future earnings guidance is often updated or changed as new figures come in, meaning investors need to pay close attention when using the forward-looking indicator.
The major downside to the forward P/E ratio is that companies often try to beat the system. They may initially claim higher earnings, then adjust the figure as they head into the next announcement of earnings. Or, they may claim a lower earnings figure in one quarter so that the next quarter beats the estimate.
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