Trailing, Forward and Justified Price to Earnings Ratios 2020-10-17, 9)14 PM Price to Earnings Ratio Obaidullah Jan, ACA, CFA Apr 21, 2019 P/E ratio (i.e. price to earnings ratio) is the ratio of a companyʼs current stock price to its earnings per share. By comparing P/E ratios, we can identify undervalued and overvalued stocks. There are two variants of P/E ratio: (a) trailing P/E ratio, which is calculated by dividing current stock price by last year EPS and (a) forward P/E ratio, which is calculated by dividing the current stock price with expected next year EPS. Price to earnings ratio tells us the dollars that must be invested in a company to earn one dollar each year. It measures how costly a stock is with reference to its ability to earn income. P/E ratio is compared across time and cross sectionally i.e. between different companies. When the P/E ratio of a company is higher than its competitors, there is a possibility that the stock might be overvalued and vice versa. Trailing P/E ratio Trailing P/E ratio is calculated by dividing the current stock price of a company by the last year earnings per share (EPS). It is the most common definition of price-to-earnings ratio. When we say just the P/E ratio, we mean the trailing P/E ratio. Trailing P/E Ratio = P0 EPS0 Where P0 is the current stock price and EPS0 is the last year annual earnings https://xplaind.com/593781/price-to-earnings-ratio Page 1 of 4 Trailing, Forward and Justified Price to Earnings Ratios 2020-10-17, 9)14 PM per share. Forward P/E ratio Forward P/E ratio is the price-to-earnings ratio variant which is calculated by dividing the current stock price by the earnings per share expected in the next 12 months. Many investors and analysts prefer the forward P/E ratio because they believe that historical performance is not a particularly good indicator of future performance and that undervaluation or over-valuation of a stock should be determined by comparing its current price with earnings expected in future. Forward P/E Ratio = P0 EPS1 Where EPS1 is the earning per share expected in the next 12 months. Justified P/E ratio A justified P/E ratio is the price to earnings ratio which is justified by the companyʼs underlying fundamentals, i.e. growth rate and cost of equity, etc. Justified P/E ratio can be determined by linking the P/E ratio with the Gordon growth model. Gordon growth model (GGM) is a single stage dividend discount model which determines a stockʼs current stock as equal to the present value of a perpetuity comprising of the stockʼs dividends. GGM equation is as follows: P0 = D1 ke − g https://xplaind.com/593781/price-to-earnings-ratio Page 2 of 4 Trailing, Forward and Justified Price to Earnings Ratios 2020-10-17, 9)14 PM Where P0 is the current stock price, D1 is the dividend per share next year, ke is the cost of equity and g is the growth rate. Dividing both sides by E1, the earning per share expected next year, the left hand of the above equation equals the forward P/E ratio and the numerator of the right-hand side equals the dividend payout ratio (DPR): P0 EPS1 = D1/EPS1 ke − g = DPR ke − g The above equation can be used to find out the P/E ratio indirectly based on the companyʼs dividend payout ratio, cost of equity and dividend growth rate. This P/E ratio is called the fundamental P/E ratio or justified P/E ratio. Example Let us calculate the trailing P/E ratio and forward P/E ratio for Intel Corporation and compare it with its justified P/E ratio to see if the stock is overvalued or undervalued: Current stock price is $54.51 Trailing twelve-month (TTM) earnings per share (EPS) is $1.99 EPS expected in next 12 months is $2.15 Dividend payout ratio is 48%, cost of equity is 9.5%% and growth rate is 7.6% The trailing P/E ratio equals current stock price of $54.51 divided by last year EPS of $1.99. It works out to 27.31 (=$54.51/$1.99). The forward P/E ratio (also called leading P/E ratio) equals P0 of $54.51 divided by next-year EPS (EPS1) of $2.15; it works out to 25.35 (=$54.51/$2.15) https://xplaind.com/593781/price-to-earnings-ratio Page 3 of 4 Trailing, Forward and Justified Price to Earnings Ratios 2020-10-17, 9)14 PM The justified P/E ratio can be calculated as follows: P0 EPS1 = DPR ke − g = 48% 9.5% − 7.6% = 25 Since the justified P/E ratio is close to the current forward P/E ratio, the stock seems to be fairly priced. by and last modified on Studying for CFA® Program? Access notes and question bank for CFA® Level 1 authored by me at AlphaBetaPrep.com Related Topics Stock Valuation PVGO Dividend Discount Model Cost of Equity Sustainable Growth Rate Earnings per Share Dividend Payout Ratio Present Value of Perpetuity https://xplaind.com/593781/price-to-earnings-ratio Page 4 of 4