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A Deeper Look at the Price-To-Earnings Ratio: Part 2

Previously, we learnt that a cheap company today may not be a cheap company 10 years from now.

Today, let’s talk about two variants of the price-to-earnings (PE) ratio we commonly see in analysts’ reports. One is the ttm (trailing twelve months) or trailing PE ratio, and the other is the forward PE ratio.

The trailing PE ratio uses the current market price of the stock and the past twelve months’ earnings whereas the forward PE ratio uses forecasted earnings from financial analysts who are covering the company.

For large and established companies, there is unlikely to be large fluctuations in earnings from year to year. However, if there is an upcoming product launch that can be vital to the company’s future, the earnings could change. Think a pharmaceutical company going for the authority approval for a new drug. The forward PE ratio could be used to determine whether the stock remains attractively priced when taking into account its future growth.

Since the earnings used in the forward PE ratio is usually a forecast, the trailing PE ratio may be more useful to determine whether a stock is undervalued. So, how can we use the trailing PE ratio in our own investments?

We can look at the trailing PE ratio versus its historical average. Being lower than the historical average is one indication of the stock is attractively priced. The PE ratio of a company against other companies in its industry should also be looked at. Again, companies with a PE ratio lower than the industry average can indicate value.

Whether a PE ratio is high or low, investors should ask themselves why this might be so.

Peter Lynch, in his book, One Up on Wall Street, suggests reasons why PE ratios can be low and how that might signal a good bargain for investors. A company could be trading at a low PE ratio as its product is boring (funeral services or garbage disposal), or there are unsubstantiated rumours (negative news) about the company that is not true. In both instances, the lack of active coverage by financial analysts means there is less attention to the stock.

Investors who are looking to uncover hidden gems might want to look for companies in those boring industries.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.