The P/E ratio is the most widely used price multiple in the investment community.
There are reasons why it is so widely used:
- Earnings power, as measured by earnings per share (EPS), is the primary determinant of investment value.
- Empirical research shows that P/E differences are significantly related to long-run average stock returns.
Certain considerations must be made however, as the ratio has flaws as well:
- Earnings can be negative, which produces a meaningless P/E ratio.
- The volatile, transitory portion of earnings makes the interpretation of P/Es difficult for analysts.
- Management discretion within allowed accounting practices can distort reported earnings, and thereby lessen the comparability of P/Es across firms.
The trailing P/E uses earnings from the 12 most recent months as its denominator.
Trailing P/E = market price per share/EPS over last 12 months
The leading P/E uses a forecasted value for the next year’s earnings for its denominator.
Leading P/E = market price per share/forecasted EPS for next 12 months