Three cases where the trailing P/E ratio actively misleads

The trailing price-to-earnings ratio is calculated by dividing a stock's current price by its diluted earnings per share over the most recent four quarters. It is the first number most investors look at, it is available on every data provider's summary page, and it is built into virtually every stock screen. It is also, in three specific situations, almost perfectly wrong.

What the P/E ratio actually measures

A P/E ratio of 20x means investors are paying $20 for every $1 of reported annual earnings. At face value: the more you pay per dollar of earnings, the more the market expects those earnings to grow, or the higher quality it thinks they are. A business growing at 30% per year deserves a higher multiple than one growing at 3% per year. A company with stable, recurring revenue deserves a higher multiple than a cyclical one. This is the intuition behind the number.

The problem is in the word "trailing." The denominator is earnings from the past year, not from the next one. If the past year was unusually bad (or unusually good), the ratio describes history rather than value.

Case 1: The earnings inflection

A company that was unprofitable for several years and just turned a small profit will have a very high trailing P/E — because the denominator, while positive, is tiny relative to the price.

Consider a business trading at $13.70 with $0.06 of diluted EPS. The trailing P/E is roughly 228x. Any screen that ranks by P/E marks it as one of the most "expensive" stocks in its universe. Any screen that filters for P/E below 25x drops it entirely. The company disappears from value and quality screens simultaneously — at the exact moment it crossed from loss-making into profitable.

This is not a hypothetical. Orion Group Holdings (ORN), a marine and concrete construction contractor, reported its first positive net income in five years in FY2025 — $2.5M on $852M of revenue — producing that 228x trailing P/E. The same year, the company generated $28.1M of operating cash flow: more than ten times its reported earnings. The cash flow, which is less distorted by the near-zero denominator problem, told a different story than the headline multiple. An inflection — the moment a company crosses from negative to positive earnings — creates the most extreme P/E readings precisely when the screen should be most curious, not least.

Case 2: The cyclical trough

Some businesses have earnings that move with commodity prices, project backlogs, or macroeconomic cycles. During a trough — when earnings are depressed relative to mid-cycle — the trailing P/E looks high even if the stock is reasonably priced.

The inverse problem also exists: during a peak — when earnings are temporarily inflated — the P/E looks cheap at exactly the wrong time. Buying a cyclical business at a low P/E during peak earnings is one of the classic value traps. But the trough version is less discussed: a company whose earnings are temporarily depressed by a price normalization or a demand cycle looks expensive on trailing earnings even at a price that is reasonable relative to normalized earnings.

Hudson Technologies (HDSN), a refrigerant reclamation company, earned $2.20 per share in 2022 — a peak year when pandemic-era supply disruptions sent refrigerant prices to unusual highs. By 2025, as those prices normalized, EPS had fallen to $0.37. At $6.23, the trailing P/E is roughly 17x — not obviously cheap for a business with declining earnings. But the trailing earnings represent the trough of a normalization, not a declining business. The regulatory backdrop (the EPA's Refrigerant Management Rule mandating reclaimed refrigerant for certain applications) is structural and did not exist in 2022. A trailing P/E computed on trough earnings looks like a fair or full valuation on what may be a cyclical floor — with a regulatory demand mechanism the historical earnings don't reflect.

Case 3: The hidden cost drag

A company running an expensive side project — R&D for a new product, a second business unit that hasn't scaled — will have lower reported earnings than its core business alone would generate. The trailing P/E reflects the entire cost structure, including the drag. If the side project is wound down, the reported earnings of the remaining business can increase substantially without any improvement in the core's performance.

Energy Recovery (ERII) spent several years building a CO2 refrigeration business for retail grocery applications within an "Emerging Technologies" segment. In FY2025, that segment consumed roughly $14.5M of operating expenses against $285K of revenue. The company as a whole reported $23M of net income and a trailing P/E of about 20.5x on $0.42 of EPS — reasonable but not obviously cheap for a business with flat revenue. In February 2026, management wound down the CO2 segment entirely. The trailing P/E on the combined entity included a full year of drag from a segment that no longer exists. Normalized earnings from the Water business alone — which earned $62M in operating income before that drag and corporate allocations — imply a materially lower forward multiple on the same stock price.

A variant of the same pattern is a divested segment rather than a wound-down one. Cass Information Systems (CASS) sold its telecom expense management business to Asignet in mid-2025 for $18M in cash. FY2024 net income was $19.2M — compressed by the costs of a segment still running on the income statement as it was prepared for sale. FY2025 net income, the first clean year, recovered to $35.1M: not because the core freight-payment business improved dramatically, but because a non-core cost structure was removed. The trailing P/E in late 2024 was pricing the segment drag as permanent.

What to use instead

None of this means the P/E ratio is useless. For stable, predictable businesses with no cyclicality and no structural cost changes, trailing P/E is a reasonable shortcut. The problem is that those are exactly the businesses already well-covered and well-priced — the ones where a screen's output is already correct.

For situations where the trailing P/E is likely to mislead, the following adjustments help:

Operating cash flow is less distorted by near-zero earnings denominators than net income. A business with positive and stable operating cash flow while reporting small or negative net income is often not as distressed as the income statement suggests.

Normalized earnings — stripping out one-time charges, restructuring costs, or identifiable cost drags — gives a better picture of what the business earns in a run-rate year. The risk is that "normalized" becomes a way to exclude inconvenient costs; the question to ask is whether the normalization is based on something that has actually happened (a segment wound down, a debt paid off) or something hoped for.

Historical margin context tells you whether current earnings are above or below the business's typical range. A company earning far below its historical gross margin is probably not permanently impaired; a company earning above it may not be permanently elevated.

The coverage gap this creates

The practical consequence of screens relying on trailing P/E is that certain categories of businesses are systematically excluded from the candidates that most investors examine. A company at an earnings inflection fails value screens at the moment of crossing into profit. A cyclical trough business looks expensive when it may be at its cheapest in years. A company winding down a cost drag looks like a stagnant business when it may be about to show its best earnings in years.

All three of these patterns produce the same output from a screen: pass. The result is that the businesses most likely to be mispriced — because their trailing earnings are the worst possible representation of their ongoing economics — are exactly the ones that automated filters route around. That is the structural gap this publication tries to cover. For the broader framework we use to distinguish a genuine coverage gap from a stock the market is right to skip, see Under-Covered vs. Correctly Ignored: How to Tell the Difference.