Chartered Financial Analyst (CFA) Practice Exam Level 2

How can trailing PE be calculated in relation to leading PE and growth rate?

1. Trailing PE = Leading PE + G

2. Trailing PE = Leading PE / (1 + G)

3. Trailing PE = Leading PE (1 + G)

4. Trailing PE = Leading PE - G

The correct answer is: Trailing PE = Leading PE (1 + G)

The correct calculation for trailing price-to-earnings (PE) in relation to leading PE and growth rate hinges on understanding how these terms interact mathematically. Trailing PE reflects the ratio of current share price to earnings over the past year, while leading PE is based on expected future earnings. The growth rate (G) is a vital component that indicates expected earnings growth. When you see the formula Trailing PE = Leading PE (1 + G), it shows that you are taking the leading PE and adjusting it by compounding it with the expected growth. This relationship makes sense because if earnings are projected to grow, the trailing PE should also reflect that growth. By multiplying the leading PE by (1 + G), you are essentially accounting for the increase in future earnings, which justifies a higher valuation, as today’s earnings are expected to grow at the rate G. Thus, if you start with the leading PE, when earnings grow by that expected rate, the trailing measure adjusts accordingly, which leads to the formulation of trailing PE as a function of leading PE and growth rate. In contrast, other formulations do not accurately reflect how growth impacts the relationship between trailing and leading PE. For example, merely adding or subtracting growth does not