# Trailing, Forward and Justified Price to Earnings Ratios ```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
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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
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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)
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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.
Studying for CFA&reg; Program? Access notes and question bank for CFA&reg; 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
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