What it means
Trailing multiples are used to evaluate a company's value by looking at its recent historical performance. This approach is backward-looking, meaning it considers actual financials rather than forecasts.
The most common trailing multiple is the Price-to-Earnings (P/E) ratio, calculated using the last 12 months' earnings. Investors and analysts prefer trailing multiples because they are based on real numbers, reducing the uncertainty associated with projections.
Trailing multiples matter because they offer a snapshot of how the market values a company's past performance. This helps investors compare companies within the same industry or assess if a stock is over or undervalued.
In practice, trailing multiples are frequently used in mergers and acquisitions, stock analysis, and investment decisions. They help investors determine a fair price for a company by comparing it to peers with similar financial performance.
While useful, trailing multiples have limitations. They do not account for future growth potential, which means a company might appear over or undervalued based solely on past data.
Investors should use them alongside other metrics to get a comprehensive view. Think of a trailing multiple like a rearview mirror in a car.
It shows you where you've been, offering a clear picture of past performance, but you still need other tools to navigate forward.
In practice
Real-world examples
Example 1
An entrepreneur evaluates a potential investment in a tech startup with a trailing P/E ratio of 15. This means investors are currently paying $15 for every $1 of earnings the company generated in the past year. By comparing this to competitors, the entrepreneur can assess whether it is a fair valuation.
Example 2
A small manufacturing firm considers acquiring a competitor. The target company has generated $2 million in revenue over the past year and has a trailing revenue multiple of 2.5. This indicates a valuation of $5 million, helping the firm decide if the acquisition price aligns with industry standards.
Example 3
A retail investor looks at a clothing retailer with a trailing P/E ratio of 18. If the industry average is 20, the retailer might be undervalued based on past earnings. On earnings of $3 per share, the shares cost $54 compared with $60 at the industry average, though the investor would also weigh future growth potential.
Think of it
Think of a trailing multiple like a rearview mirror in a car. It shows you where you've been, offering a clear picture of past performance, but you still need other tools to navigate forward.
Formula
Calculation
The trailing P/E ratio is calculated as the current share price divided by the earnings per share (EPS) over the last 12 months. For example, if a company's current share price is $30 and its EPS over the past year is $2, the trailing P/E ratio is 15 ($30/$2). This means investors are paying $15 for every $1 of past earnings.
You can also work backwards to estimate a value. If similar companies trade at a trailing P/E of 18 and your company earned $2 per share, the implied share price is 18 x $2 = $36, which is $6 (20%) above the current $30. The same logic works for other trailing metrics: a company with $2 million of revenue and a trailing revenue multiple of 2.5 is valued at 2.5 x $2,000,000 = $5,000,000.Case study
Seen in the real world
Bright Lights Ltd, a fictional LED manufacturing company, has experienced steady growth over the past year. With a trailing P/E ratio of 12, the company generated $10 million in earnings over the last 12 months. Competitors in the same industry have an average trailing P/E of 15. This suggests that Bright Lights might be undervalued compared to its peers, given its solid earnings performance.
At a multiple of 12, the market values the company at 12 x $10 million = $120 million, whereas the peer average of 15 would imply 15 x $10 million = $150 million. That gap of $30 million, or 25%, is what an investor would investigate. Investors considering Bright Lights would note this trailing multiple, comparing it with industry averages to gauge investment potential. However, they would also check whether the past 12 months included one-off gains and consider future earnings projections and market dynamics before making a decision.
Watch out
Common mistakes
- Relying solely on trailing multiples without considering future growth potential.
- Comparing trailing multiples across different industries where norms vary.
- Ignoring the impact of one-off events that might have skewed past earnings.
Questions
People also ask
Why do investors use trailing multiples?
Investors use trailing multiples to evaluate a company's past performance and compare it to industry peers, helping determine if a stock is fairly valued.
Are trailing multiples better than forward multiples?
Each has its purpose; trailing multiples are based on actual past performance, while forward multiples rely on projections. Using both provides a balanced view.
Can trailing multiples change over time?
Yes, trailing multiples change as new financial data becomes available, reflecting the company's most recent performance.