P/E Multiple Selection: Trailing, Forward, and CAPE

Why P/E Matters (The Core Question)

How much are you willing to pay for each dollar of earnings? That is what P/E answers.

P/E = Current Stock Price / Earnings Per Share

A stock trading at $50 with $2.50 in EPS has a P/E of 20. You are paying $20 for every $1 of annual earnings the company generates.

The point is: P/E is a shorthand for valuation. High P/E suggests the market expects growth. Low P/E suggests the market expects problems—or has simply overlooked the stock.

Trailing vs Forward P/E (Choose Carefully)

Trailing P/E

P/E = Current Price / EPS (last 12 months)

Uses actual reported earnings. No forecasting required. You know exactly what the company earned.

Advantage: Based on fact, not projection Disadvantage: Backward-looking; one-time items can distort

Forward P/E

P/E = Current Price / Estimated EPS (next 12 months)

Uses analyst consensus estimates for future earnings.

Advantage: Forward-looking; reflects expected performance Disadvantage: Estimates are often wrong; analyst bias exists

The durable lesson: Academic research shows most analysts set price targets using trailing P/E, not forward P/E. The historical number provides an anchor; forward estimates introduce uncertainty. Use trailing P/E as your base case, forward P/E as a cross-check.

Sector P/E Ranges (Why Comparisons Fail Across Industries)

Tech at 40x and utilities at 15x are not comparable. Structural differences in growth rates, capital requirements, and competitive dynamics create permanent P/E differences across sectors.

High P/E Sectors (35-45x)

Why: High growth expectations, asset-light models, scalability

Moderate P/E Sectors (18-25x)

Why: Steady growth, defensive characteristics, moderate capital intensity

Low P/E Sectors (8-20x)

Why: Regulated returns, cyclicality, capital intensity, lower growth

The point is: A tech stock at 20x might be cheap. A utility at 20x might be expensive. Always compare within sectors, never across them.

Shiller CAPE (Cyclically Adjusted P/E)

Standard P/E uses one year of earnings—a single data point that cycles with the economy. CAPE smooths this by using 10 years of inflation-adjusted earnings.

CAPE = Current Price / Average of 10-Year Inflation-Adjusted Earnings

Historical CAPE Benchmarks

Why this matters: The S&P 500 CAPE at 39-40x sits well above both historical median (16) and modern average (24.5). Either the market is expensive, structural factors justify higher multiples, or both.

Interpreting CAPE

CAPE significantly above average: Expected future returns are lower. Does not mean a crash is imminent—just that entry prices are high.

CAPE near average: Reasonable expectations for historical returns.

CAPE below average: Higher expected returns. Often occurs during recessions when earnings collapse and prices follow.

The durable lesson: CAPE predicts 10-year forward returns better than any single-year metric. High CAPE does not time markets but does set expectations. At CAPE of 40, expecting 10%+ annual returns is historically unsupported.

The PEG Ratio (Adjusting for Growth)

P/E alone ignores growth. A 30x P/E for a company growing 30% annually might be cheap; the same 30x for a company growing 5% is expensive.

PEG = P/E Ratio / Annual EPS Growth Rate

Example:

• Company A: P/E of 25, growing at 25% -> PEG = 1.0
• Company B: P/E of 25, growing at 10% -> PEG = 2.5

General interpretation:

• PEG < 1: Potentially undervalued relative to growth
• PEG = 1: Fairly valued for growth
• PEG > 2: Potentially overvalued relative to growth

Why this matters: PEG normalizes valuation for growth differences. Two 25x P/E stocks are not equivalent if one grows three times faster.

Caution: PEG assumes growth rates are sustainable and comparable. It breaks when growth estimates are unreliable or when comparing different-quality growth.

Common Errors in P/E Analysis

Error 1: Comparing P/E Across Sectors

A 12x energy stock is not "cheap" versus a 40x tech stock. They operate in different universes with different growth profiles, capital requirements, and risk characteristics.

Rule: Compare companies within the same sector, similar size, and comparable growth profiles.

Error 2: Using P/E for Negative Earnings

When earnings are negative, P/E is either meaningless or negative. Neither helps you.

Alternative: Use EV/Revenue for unprofitable companies, or focus on when profitability arrives and what earnings will be then.

Error 3: Ignoring Earnings Quality

Not all earnings are equal. One-time gains inflate P/E. Aggressive accounting inflates earnings temporarily. Stock-based compensation reduces true cash profits.

Rule: Adjust EPS for non-recurring items. Use operating earnings or normalized earnings when standard EPS is distorted.

Error 4: Anchoring on Historical P/E

"It used to trade at 25x, so 20x must be cheap." Not necessarily. Business quality changes. Competition intensifies. Growth slows. Past multiples do not guarantee future valuation support.

The point is: P/E is a starting point, not an answer. It summarizes what the market thinks; your job is to decide whether the market is right.

When P/E Fails Completely

Do not use P/E for:

• Pre-revenue companies
• Cyclical companies at earnings peaks (P/E looks low before earnings collapse)
• Companies with heavy non-cash charges distorting earnings
• Turnaround situations where current earnings are temporarily depressed

Better alternatives:

• EV/Revenue for unprofitable growth companies
• EV/EBITDA for capital-intensive businesses
• P/B for financial institutions

Practical P/E Analysis Process

1. Calculate trailing P/E using last 12 months EPS
2. Compare to sector median from Damodaran or similar sources
3. Calculate forward P/E using consensus estimates
4. Check CAPE for market-level context
5. Calculate PEG if comparing growth stocks
6. Adjust for quality (one-time items, accounting differences)
7. Form a view on whether premium/discount is justified

The durable lesson: P/E tells you what the market believes. Your job is to determine whether those beliefs are reasonable, conservative, or aggressive—then act accordingly.

Next Step

Pull P/E data for five companies in a single sector (technology, healthcare, or consumer staples). Calculate trailing P/E, forward P/E, and PEG for each. Identify which trades at the highest premium to sector median and which at the deepest discount. Document what fundamentals (growth rates, margins, market position) might justify the valuation differences. This exercise reveals whether the market is pricing in factors you may have missed.