Chartered Financial Analyst (CFA) Practice Exam Level 2

What might a growing discrepancy between trailing and leading PE indicate about a company?

1. Changes in dividend policy

2. Imminent financial distress

3. Declining investor confidence

4. Increases in market share

The correct answer is: Declining investor confidence

A growing discrepancy between trailing and leading price-to-earnings (PE) ratios typically suggests that investors' expectations for future earnings are diverging from past earnings performance. When the trailing PE is significantly higher than the leading PE, it often indicates that the market has become concerned about the company's future growth prospects. This concern can stem from various factors, including potential earnings deterioration or less favorable market conditions. In this context, a decline in investor confidence is reflected in their willingness to value the company's future earnings lower than its historical earnings. Essentially, investors are signaling that they expect a downturn in profitability or growth, leading to a more cautious, bearish market perception. This can be influenced by negative news, shifts in market trends, or a reevaluation of the company's competitive position. While other factors, such as changes in dividend policy or increases in market share, can affect PE ratios, they do not inherently lead to a discrepancy between trailing and leading PE. For instance, changes in dividend policy might impact cash flows but wouldn’t directly create a divergence in earnings expectations. Similarly, while increasing market share typically fosters positive investor sentiment and can enhance future earnings outlook, it generally would not contribute to a growing discrepancy between trailing and leading PE ratios.