Chartered Financial Analyst (CFA) Practice Exam Level 2

What does it indicate when the leading PE is greater than trailing PE?

1. The growth rate is increasing

2. The market is undervalued

3. The growth rate is negative

4. The company has no growth potential

The correct answer is: The growth rate is negative

When the leading price-to-earnings (PE) ratio is greater than the trailing PE ratio, it typically signifies that the market expects future earnings growth to be stronger than current earnings. This relationship suggests that the company is experiencing positive growth expectations, with the leading PE reflecting earnings projections based on anticipated future performance. The leading PE uses estimated future earnings over the next twelve months, while the trailing PE relies on earnings from the past twelve months. Therefore, if the leading PE is higher, it generally means investors believe that earnings will grow, not decrease. A higher leading PE in comparison to the trailing PE could indicate that the market is pricing in an expectation of increased earnings, rather than pointing to negative growth. Hence, the observation that the leading PE exceeds the trailing PE does not logically lead to the conclusion that the growth rate is negative.