Choose comparable peers and tell trailing multiples apart from forward ones
The idea
A multiple is only as useful as the comparison it rests on. A good peer group shares the target's business mix, growth, risk, size and accounting basis, and industry classification is a starting point rather than an answer. Price multiples such as P/E, P/B and P/S compare equity value with per-share measures; enterprise value multiples such as EV/EBITDA compare the value of the whole firm with pre-interest measures, which suits companies with different leverage. Trailing multiples use the last reported twelve months and are factual but can include one-off items. Forward multiples use forecasts and are more relevant but only as good as the forecast. Comparing current multiples with a company's own history and with projected multiples shows whether a rating reflects the business or a temporary distortion.
A practice question
A forward P/E differs from a trailing P/E in that its denominator uses:
- EPS reported over the past twelve monthsWhy not: That is the trailing P/E denominator, which looks back at earnings already reported.
- expected EPS for the next twelve months — correct
- the average EPS of the peer groupWhy not: Peer EPS is not used in either multiple; each is the firm's own price divided by its own earnings.
Trailing P/E divides the current price by the last twelve months' EPS; forward (leading) P/E divides it by forecast EPS for the next twelve months or fiscal year.
A harder one
Dunmore Chemicals trades at 45.00. Its EPS over the last twelve months was 3.00 and analysts forecast EPS of 3.60 for the next twelve months. Its forward P/E is closest to:
- 12.5 — correct
- 15.0Why not: Divides by the last twelve months' EPS, which gives the trailing P/E rather than the forward P/E.
- 13.6Why not: Uses the average of past and forecast EPS (3.30), which is neither the trailing nor the forward denominator.
Forward P/E = price / forecast EPS = 45.00 / 3.60 = 12.5. The trailing P/E is 45.00 / 3.00 = 15.0.
The hardest tier
Fenwick Media trades at 60.00. Its trailing EPS of 2.50 is after a one-off restructuring charge of 0.50 per share, and forecast EPS is 3.30. For comparison with peers, its trailing P/E based on normalised earnings is closest to:
- 20.0 — correct
- 24.0Why not: Uses reported EPS including the non-recurring charge, which inflates the trailing P/E.
- 18.2Why not: Uses forecast EPS, which gives a forward P/E and mixes up the multiple being compared.
Normalised trailing EPS = 2.50 + 0.50 = 3.00, so trailing P/E = 60.00 / 3.00 = 20.0. Removing the one-off charge makes the multiple comparable with peers.
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