Trailing Price to Earnings Ratio & Stock Prices

What is the Trailing Price to Earnings Ratio

The trailing price to earnings ratio is the most widely used P/E ratio in fundamental analysis.  This is because the trailing P/E ratio actually measures a stocks per share earnings over the previous twelve months.  This allows an investor to quickly assess how well the stock has performed within the context of its industry over the last year.

Trailing Price to Earnings Ratio Equation

Below is the equation for the trailing price to earnings ratio:

Trailing P/E Ratio = (Current Share Price/Trailing Twelve Month's Earnings Per Share)

Price to Earnings and Stock Prices

The trailing price to earnings indicator can often be a leading indicator of sorts when determining if stocks are properly valued.  Historically going back to 1960 the trailing price to earnings ratio has been approximately 18.  This means that when the market begins to see 12-month trailing p/e ratios that exceed 30 the market is somewhat overvalued.  Now this does not mean that the market can't go higher over the near-term.  Remember the market is simply the physical representation of the trading community's perception of value.  For example, during the internet bull market, the trailing p/e ratio was able to climb over 60.  So, if an investor sees a trailing p/e ratio of 10, it does not mean he or she should run out and buy stocks.  Nor does a trailing p/e ratio over 30 mean an investor needs to go into cash.  Investors simply need to keep a watchful eye as the trailing p/e ratio begins to hit certain extremes and use it as a roadmap for any pending moves.

Historical Chart of S&P 500 and Trailing P/E Ratio

In the below chart you can see how a low p/e ratio led to the rally from the mid-90s into 2000.  This same logic held true from 2004- 2008 as the market moved upward in a slow methodical fashion.  But notice how the market has since sold off while the p/e ratio has remained historically low.