Chartered Financial Analyst (CFA) Practice Exam Level 2

What does a leading PE ratio mostly reflect?

1. Current earnings

2. Projected earnings growth

3. Historical price movements

4. Inflation adjustments

The correct answer is: Projected earnings growth

The leading price-to-earnings (PE) ratio primarily reflects projected earnings growth. This ratio is calculated using the current stock price and expected earnings per share (EPS) over the next 12 months. Investors utilize the leading PE ratio as a gauge of a company's future earnings potential, which is vital for making investment decisions. Essentially, this ratio offers insight into how much investors are willing to pay today for a future stream of earnings, thus emphasizing growth expectations. The focus on projected earnings underscores its importance in valuation, as it incorporates analysts' forecasted growth trends and overall market sentiment regarding the company's future performance. By emphasizing anticipated earnings, it provides a forward-looking perspective, which is particularly valuable in assessing growth stocks within sectors characterized by rapid innovation or expansion. In contrast, other factors like current earnings would typically relate to the trailing PE ratio, which evaluates past performance rather than future projections. Historical price movements relate to market trends and performance over time but do not directly inform projections of future earnings. Inflation adjustments are also not represented in the leading PE ratio, which focuses solely on nominal figures without adjusting for price level changes.