CFA Level II Exam · Market-Based Valuation: Price and Enterprise Value Multiples

Price to Earnings (P/E) Ratio for CFA Level II

Updated 7 October 2026 · Fact-checked

The P/E ratio is share price divided by earnings per share. Trailing P/E uses the last four quarters of EPS; forward P/E uses expected EPS. To solve exam questions, pick the right EPS, normalize it if earnings are cyclical or unusual, then compare with a justified P/E built from payout, growth and required return.

Understand Price to Earnings (P/E) Ratio

The price to earnings (P/E) ratio tells you how many rupees or dollars investors pay for one unit of a company's earnings. A P/E of 20 means the market pays 20 times each unit of EPS. It is the most widely used valuation multiple, because earnings drive value and EPS is easy to find.

There are two main versions. Trailing P/E divides current price by EPS over the most recent four quarters (or last fiscal year). Forward P/E (also called leading P/E) divides current price by expected EPS for the next year or four quarters. Trailing uses reported data, so it is verifiable but backward-looking. Forward relies on forecasts, so it is forward-looking but can be biased. Always keep the numerator and denominator consistent when comparing firms.

Reported EPS can mislead. Cyclical firms have depressed EPS in a downturn, which inflates P/E, and peak EPS in a boom, which deflates it. Analysts therefore compute normalized EPS. Two common methods are the historical average EPS method (average EPS over a full business cycle) and the average return on equity method (average ROE over a cycle multiplied by current book value per share). You should also remove non-recurring items, and adjust for differences in accounting choices, before comparing companies.

The fundamental drivers of P/E come from the Gordon growth model. Dividing the value formula by expected EPS gives a justified forward P/E = payout ratio ÷ (r − g). A higher payout, higher growth and lower required return all raise P/E. The trailing version multiplies by (1 + g). So P/E rises when growth is higher or risk is lower, which is why you must compare like with like.

The PEG ratio is the P/E divided by the expected growth rate in earnings (in percentage points). It lets you compare firms with different growth. Its limits are real: it assumes a linear relationship between P/E and growth, ignores risk, and ignores the duration of growth.

Key formulas to remember

Trailing P/E: Trailing P/E = Price ÷ EPS over last four quarters; Uses reported EPS. Price is current market price.
Forward (leading) P/E: Forward P/E = Price ÷ Expected EPS (next year); Uses forecast EPS, so it carries forecast error.
Normalized EPS: historical average: Normalized EPS = average EPS over a full business cycle; Simple but ignores changes in company size.
Normalized EPS: average ROE: Normalized EPS = average ROE over cycle × current book value per share; Reflects the current capital base.
Justified forward P/E: Justified P/E1 = (D1 ÷ E1) ÷ (r − g) = payout ratio ÷ (r − g); Needs r > g. Based on the Gordon growth model.
Justified trailing P/E: Justified P/E0 = [(D0 ÷ E0) × (1 + g)] ÷ (r − g); Equals forward justified P/E × (1 + g).
PEG ratio: PEG = P/E ÷ (expected earnings growth rate in %); Lower PEG suggests cheaper per unit of growth, other things equal.
Price from P/E: Value = Justified P/E × EPS (matching trailing or forward); Match the P/E type to the EPS type.

How to solve Price to Earnings (P/E) Ratio questions

Use this sequence for any P/E question in an item set.

1Identify which P/E the question wants: trailing or forward, and justified or market-observed.
2Find the matching EPS in the vignette exhibits. Check the period and whether it is diluted, continuing operations or includes one-offs.
3If earnings are cyclical or distorted, compute normalized EPS using the method the vignette names or supplies data for.
4For a justified P/E, extract payout ratio (or D and E), required return r and growth g. Check r > g and that g is in the same units as r.
5Apply the formula and match trailing with E0 and (1 + g), forward with E1.
6Multiply P/E by EPS if asked for value, or compare justified P/E with market P/E to judge over- or undervaluation.
7For PEG, divide P/E by growth in whole percentage points, then compare only with firms of similar risk and growth duration.

Quickest way: Match, then plug

When to use it: When time is short and the vignette gives most inputs directly.

Write the payout ratio, r and g in the margin immediately.
Compute payout ÷ (r − g) for forward; multiply by (1 + g) for trailing.
Check the sign of the answer: if the justified P/E is above market P/E, the stock looks undervalued.
For normalized EPS, pick the one method the data supports; do not compute both.
Eliminate options that mix trailing P/E with forward EPS.

Common mistakes in Price to Earnings (P/E) Ratio

Applying a forward P/E to trailing EPS (or the reverse).
Both are called P/E and the vignette lists several EPS figures.
Fix: Label each EPS as E0 or E1 before using it, and pair forward with E1 only.
Forgetting the (1 + g) factor for the trailing justified P/E.
Students memorise only the forward formula.
Fix: Remember trailing = forward × (1 + g), because D0 is grown into D1.
Entering growth as 5 instead of 0.05 in r − g.
Mixing PEG convention, which uses whole numbers, with the Gordon model, which uses decimals.
Fix: Use decimals in r − g. Use whole percentage points only in the PEG denominator.
Reading a high P/E on depressed earnings as 'expensive'.
Ignoring the business cycle for cyclical firms.
Fix: Normalize EPS first, then judge the P/E.
Treating a low PEG as proof of undervaluation.
PEG looks like a complete adjustment for growth.
Fix: Check risk and how long growth will last. PEG assumes a linear link and ignores both.
Using the average ROE method with average book value instead of current book value.
Confusing which input is averaged.
Fix: Average the ROE over the cycle, then multiply by current book value per share.

Worked examples

Example 1

Vignette: Orion Ltd has current EPS (E0) of 4.00 and pays out 40% of earnings. Its required return is 10% and expected dividend growth is 6%. Orion trades at 45. Q1: What is the justified forward P/E? Q2: What is the justified trailing P/E? Q3: Based on the trailing P/E, is Orion over- or undervalued?

Show the solution

Q1: Payout = 0.40. r − g = 0.10 − 0.06 = 0.04.
Forward justified P/E = 0.40 ÷ 0.04 = 10.0.
Q2: Trailing justified P/E = 10.0 × 1.06 = 10.6.
Q3: Market trailing P/E = 45 ÷ 4.00 = 11.25.
Justified 10.6 is below market 11.25, so the stock trades above its justified value.

Answer: Forward justified P/E = 10.0; trailing justified P/E = 10.6; Orion appears overvalued (market trailing P/E 11.25 vs justified 10.6).

Example 2

Vignette: Delta Mining is cyclical. Its EPS over the last full cycle was: 1.20, 2.80, 3.40, 1.60 and 1.00. Average ROE over the cycle was 12%. Current book value per share is 25.00. Current price is 30.00. Q1: Normalized EPS by historical average? Q2: Normalized EPS by average ROE? Q3: Price to normalized EPS using the average ROE method?

Show the solution

Q1: Sum = 1.20 + 2.80 + 3.40 + 1.60 + 1.00 = 10.00. Average = 10.00 ÷ 5 = 2.00.
Q2: Normalized EPS = 0.12 × 25.00 = 3.00.
Q3: P/E on normalized EPS = 30.00 ÷ 3.00 = 10.0.

Answer: Historical average EPS = 2.00; average ROE method EPS = 3.00; P/E on ROE-normalized EPS = 10.0.

Exam tips

Check whether the vignette asks for trailing or forward before touching the formula; it is the most common trap.
Read the exhibit footnotes for one-off gains, losses and share count changes that change EPS.
Use the average ROE method when book value is given; use the historical average when only an EPS series is given.
For PEG questions, expect a comparison between companies and a limitation. Name risk, growth duration and the linear assumption.
No marks are lost for wrong answers, so eliminate options with the wrong P/E type and guess from the rest.

Price to Earnings (P/E) Ratio in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

ACCA Applied SkillsMarket-Based Valuation: P/E and Earnings Yield

Price to Earnings (P/E) Ratio: frequently asked questions

What is the difference between trailing P/E and forward P/E?

Trailing P/E divides price by EPS from the last four quarters. Forward P/E divides price by expected EPS for the coming period. Trailing is based on facts but looks backward; forward looks ahead but depends on forecasts.

How do you calculate normalized EPS?

Use either the historical average EPS over a full business cycle, or average ROE over a cycle multiplied by current book value per share. The second method reflects the current capital base, so it is often better when the firm has grown or shrunk.

What is the justified P/E formula in CFA Level II?

Justified forward P/E = payout ratio ÷ (r − g). For the trailing version, multiply by (1 + g). It requires the required return r to be greater than the growth rate g.

What are the advantages and limitations of the PEG ratio?

PEG lets you compare P/Es across firms with different growth, and it is simple to compute. It assumes a linear relationship between P/E and growth, ignores risk differences and does not capture how long growth lasts.