Trailing P/E ratio is commonly used to evaluate a company’s profitability, based on the trailing twelve months (TTM). When investors analyze a stock, it is important to be able to analyze its earnings. The trailing P/E ratio, compares the stock price with the earnings based on the last 12 months. When you calculate the price-to-earnings ratio of a stock, you should use the earnings over the last year. This allows you to value the company more accurately.
Difference between trailing P/E ratio and forward P/E ratio
The trailing price-to-earnings is based on the earnings over the last year. The forward P/E ratio, focuses on the projected future earnings.
The trailing P/E ratio is calculated by dividing the share price, by the earnings over the last 12 months.
Trailing P/E ratio = Current stock price/ EPS over the last 12 months
Forward P/E ratio is calculated based on the expected earnings over the next year.
Forward P/E ratio = Current stock price/Expected EPS over the next 12 months
Trailing P/E ratio is a measure of the company’s profitability. It can be calculated based on the previous earnings or future earnings. It is useful when conducting valuation. As it gives a clear picture of the company’s current value. Forward P/E ratio is commonly used to make projections. It is based on estimates about the earnings. This can also affect the valuation. Although both are very useful metrics, when you analyze a stock. Trailing P/E ratio should be used to value a company at any given time.
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 is better to use forward price-to-earnings. Because the current earnings might not give full scope of what the earnings will be like in the near future. Therefore the forward P/E ratio is more useful when you want to predict the profitability. Therefore it allows you to understand the company’s ability to generate future earnings.
Advantages of using trailing price-to-earnings ratio
P/E ratio is a great and simple way to measure a company’s ability to generate profits. It also allows investors to compare several companies, based on the earnings over the last 12 months. It can be used to determine the valuation of certain companies, and to compare stocks in the same sector.
Trailing price-to-earnings ratio is useful to find higher quality companies. If there are two companies in the same sector with different trailing P/E ratios. It simply means that the market is attributing different quality scores to those stocks. A higher P/E ratio is usually attributed to higher quality companies. The trailing price-to-earnings ratio is the most common ratio to value mature, and stable companies.
Disadvantages of using trailing price-to-earnigns ratio
The trailing P/E ratio fails to consider the projections and estimated earnings the company will have in the future. This metric might not be sufficient to analyze certain growth stocks. A company that is growing at a fast pace, will often be viewed by investors as more desirable.
It will deserve a premium, over a similar company that might not be growing, or it is growing at a slower pace. When a company has a lower forward price-to-earnings ratio than its trailing P/E ratio – it means that the company’s earnings are expected to grow, going forward. This is perhaps the greatest disadvantage of using the trailing price-to-earnings ratio. As it does not contemplate the future expected earnings.
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