How to Use Trailing P/E and Forward P/E

Stock Investment Series A-Z |

Halal Investment Series Part 16

If you ask an investor to name the most popular stock market metric other than price, the price to earnings ratio (P/E) -Trailing P/E and Forward P/E- is likely to come to mind. The P/E ratio is not only the most well-known indicator of an equity’s true value as well as remarkably simple to calculate.

The trailing PE calculates the price-earnings ratio using the company’s earnings per share over the previous 12 months. The forward PE calculates the price-earnings ratio using the company’s forecasted earnings per share over the next 12 months.

The price to earnings (PE) ratio assesses the relative value of corporate stocks, determining whether they are undervalued or overvalued. It is calculated as the ratio of the current share price to earnings per share.

 

Forward P/E

Investors calculated Forward P/E ratios using future earnings guidance rather than trailing figures. This forward-looking indicator, also known as “estimated price to earnings,” is useful for comparing current earnings to future earnings. Furthermore, it provides a clearer picture of what earnings will look like without changes and other accounting adjustments.

However, the forward P/E metric has inherent flaws, such as companies underestimating earnings in order to beat the estimated P/E during the announcement of the next quarter’s earnings. Other companies may overestimate the estimate and then adjust it in their next earnings report. Furthermore, external analysts may provide estimates, which may or may not be accurate.

Forward PE Ratio Formula = Price Per Share / Forecasted EPS over the next 12 months

Must Read: Evaluating Stocks: Understanding and Applying P/E and PEG Ratios

Trailing P/E

To calculate the trailing P/E ratio is by dividing the current share price by the total EPS earnings over the previous 12 months. Many investors and analysts used the P/E ratio because it’s the most objective, assuming the company reported earnings correctly. Because they don’t trust other people’s earnings estimates, some investors prefer to look at the trailing P/E ratio.

However, trailing P/E has some drawbacks, one of which is that a company’s past performance does not predict future behavior. As a result, investors should make investments based on future earnings potential rather than past performance. Another issue is that the EPS number remains constant while stock prices fluctuate. If a major company event causes the stock price to rise or fall significantly, the trailing P/E will be less reflective of those changes.

Trailing PE Ratio Formula (TTM or Trailing Twelve Months) = Price Per Share / EPS over the previous 12 months.

Why Use the Forward P/E Ratio?

Investors often prefer the forward P/E ratio because it provides insights into what the market expects in terms of a company’s future earnings. It helps investors make decisions based on projected performance rather than relying solely on past results.

For instance, if a company is expected to grow significantly in the coming years, the forward P/E ratio may be lower than the trailing P/E, suggesting that the current price is relatively undervalued based on future earnings potential. Conversely, a higher forward P/E ratio might indicate that the stock is overvalued or that earnings are expected to decline.

How to Calculate the Forward P/E Ratio

Step-by-Step Calculation

Calculating the forward P/E ratio is straightforward, but it requires accurate estimates of future earnings. Here’s a step-by-step guide:

  1. Determine the Current Share Price: This is the market price at which the stock is currently trading.
  2. Obtain the Estimated EPS: Estimated earnings per share for the next 12 months can be sourced from company guidance, analyst forecasts, or financial news outlets.
  3. Apply the Formula:​

For example, if a company’s current share price is $50, and the estimated EPS for the next year is $5, the forward P/E ratio would be:

This ratio indicates that investors are willing to pay $10 today for every dollar of future earnings.

Where to Find Projected Earnings Per Share (EPS)

Projected EPS figures can typically be found in a company’s earnings guidance, which is often released quarterly. Additionally, financial analysts publish earnings estimates, which can be accessed through financial news platforms like Bloomberg, Reuters, or even through brokerage accounts that provide research reports.

Comparing Forward P/E with Trailing P/E

Advantages of Forward P/E Over Trailing P/E

The forward P/E ratio has several advantages over the trailing P/E ratio:

  • Focus on Future Performance: Forward P/E is based on expected earnings, making it a more relevant measure for investors who are interested in future growth prospects.
  • Better for High-Growth Companies: For companies expected to grow rapidly, the forward P/E ratio provides a clearer picture of their potential, which might not be evident from past earnings alone.

Limitations of Forward P/E

Despite its advantages, the forward P/E ratio is not without its limitations:

  • Reliance on Estimates: The accuracy of the forward P/E ratio depends on the reliability of earnings estimates, which can be influenced by analyst bias, changes in market conditions, or unforeseen events.
  • Potential for Misleading Results: Companies might manipulate their earnings guidance to beat estimates, leading to potential misinterpretations of the forward P/E ratio. Additionally, differences in accounting practices can affect the comparability of forward P/E ratios across companies.

Sector-Specific Forward P/E Ratios

How Forward P/E Varies Across Industries

Forward P/E ratios can vary significantly across different sectors due to differences in growth rates, risk profiles, and capital structures. For example, technology companies, which often have high growth expectations, tend to have higher forward P/E ratios compared to more stable sectors like utilities.

For instance, the forward P/E ratio for healthcare technology companies can be over 100, reflecting their rapid growth potential. In contrast, sectors like financial services, where earnings are more predictable, tend to have forward P/E ratios in the range of 10-20.

What Constitutes a “Good” Forward P/E Ratio?

A “good” forward P/E ratio varies depending on the industry and the company’s growth prospects. Generally, a forward P/E ratio between 10 and 25 is considered healthy. Ratios below 10 might indicate that a company is undervalued, but they can also suggest financial instability. Conversely, ratios above 25 could indicate overvaluation, especially if the company’s growth prospects don’t justify such a high multiple.

Forward P/E in Investment Decision-Making

Using Forward P/E to Identify Growth Stocks

Investors often use the forward P/E ratio to identify growth stocks—companies expected to increase their earnings at an above-average rate compared to others in the market. A lower forward P/E relative to the industry average might suggest that a stock is undervalued, especially if the company is expected to deliver strong earnings growth in the future.

Combining Forward P/E with Other Valuation Metrics

While the forward P/E ratio is a useful tool, it should not be used in isolation. Investors often combine it with other metrics like the PEG (Price/Earnings to Growth) ratio, which adjusts the P/E ratio for the growth rate of a company, or the EV/EBITDA (Enterprise Value/Earnings Before Interest, Taxes, Depreciation, and Amortization) ratio, which offers a broader view of a company’s value relative to its earnings.

Also Read: Avoid These 6 Bad Mindsets in Stock Investing: Essential Tips for Investors

Real-World Examples of Forward P/E Ratio

Case Study: Forward P/E Ratio of Amazon

To illustrate the use of the forward P/E ratio, consider Amazon. As of a recent report, Amazon had a forward P/E ratio of around 70, reflecting investor expectations of continued high growth in its core e-commerce and cloud computing businesses. This high forward P/E ratio suggests that investors are willing to pay a premium for Amazon’s future earnings, betting on the company’s ability to maintain its growth trajectory.

Comparative Analysis: Forward P/E Ratios of Tech Giants

Comparing the forward P/E ratios of major tech companies like Apple, Google, and Microsoft can provide insights into how the market values these companies relative to their expected earnings. For instance, Apple’s forward P/E ratio might be lower than Google’s, indicating different growth expectations and risk assessments by investors.

Common Misconceptions About Forward P/E

Forward P/E as a Perfect Predictor

One common misconception is that the forward P/E ratio is a foolproof predictor of future stock performance. However, because the ratio is based on estimates, it can be subject to significant revisions if actual earnings differ from expectations.

Overemphasis on Forward P/E in Volatile Markets

Another misconception is that forward P/E ratios are always reliable, even in volatile markets. In reality, during periods of market turbulence, earnings estimates can become highly uncertain, making the forward P/E ratio less reliable as a valuation tool.

Must Read: Debunking the 5 Biggest Myths of Stock Market

Frequently Asked Questions (FAQ)

  • What is the difference between forward P/E and trailing P/E?
    • The forward P/E ratio uses forecasted earnings for the next 12 months, while the trailing P/E ratio is based on earnings from the past 12 months. Forward P/E is forward-looking, while trailing P/E is backward-looking.
  • Can the forward P/E ratio be negative?
    • Yes, the forward P/E ratio can be negative if the estimated earnings are negative, indicating that the company is expected to make a loss in the upcoming period.
  • How often are forward P/E estimates updated?
    • Forward P/E estimates are typically updated quarterly, following the release of company earnings reports and analyst revisions.
  • Is a low forward P/E ratio always a good sign?
    • Not necessarily. A low forward P/E ratio might indicate undervaluation, but it could also suggest that the market has low expectations for the company’s future earnings, possibly due to financial instability or poor market conditions.
  • How does inflation affect the forward P/E ratio?
  • Inflation can affect the forward P/E ratio by reducing a company’s earnings projections due to higher costs, which could raise the ratio if stock prices remain unchanged. Additionally, inflation often leads to higher interest rates, which can lower stock valuations and potentially decrease the forward P/E ratio. Thus, inflation impacts both the earnings estimates and stock price, making it an important consideration for investors.