If investors were to name the most popular stock market metrics, other than price, it would likely be the price to earnings ratio (P/E). The P/E ratio is the best-known indicator of true value and the easiest to understand and calculate: simply divide the current stock price by the earnings per share (EPS) and you know the P/E. The current stock price (P) is pretty straightforward. Investors routinely debate if the price of a company is the current reflection of its value, but everybody agrees that the price represents what an investor will pay for the stock right now. The EPS (E) is not so easy.

Understanding EPS
EPS comes in two main varieties. The first is what you see listed in the fundamentals section of most finance sites; it says something like "P/E (ttm);" ttm is a Wall Street acronym for trailing 12 months. This is a number reported as fact, based on the company's performance over the past 12 months. The other type of EPS is found in a company's earnings release, which often provides EPS guidance. This is the company's best educated guess of what it will earn in the future. Because there are two types of EPS metrics, there are also two most common types of P/E ratios: Forward P/E and Trailing P/E.

Forward P/E
Forward P/E uses the future earnings guidance instead of trailing figures. Sometimes called "estimated price to earnings," this forward-looking indicator is useful for comparing current earnings to future earnings, as well as gaining a clearer picture of what earnings will look like without charges and other accounting adjustments.

There are problems with forward P/E, however. A company's stated estimate could have any number of motivations behind it. Most companies could underestimate earnings so they are set up to beat the estimate P/E when the next quarter's earnings are announced. Others may overstate the estimate and later adjust it going into their next earnings announcement. Also, not only do companies provide estimates, but analysts do as well, and these estimates can be different.

If you're using forward P/E as a central basis of your investment thesis, research the companies regularly. If the company updates its guidance, this will affect the forward P/E in a way that might make you reconsider your opinion.

Trailing P/E
Trailing P/E relies on what is already done. It uses the current share price and divides by the total EPS earnings over the past 12 months. It's the most popular P/E metric because it's the most objective. Since it uses what already happened, there's little room for debate, assuming the company reported earnings accurately. Some investors prefer to look at the trailing P/E because they don't trust somebody else's earnings estimates.

Trailing P/E is not without problems, however. What a company did in the past is not necessarily an indicator of what it will do in the future. Most investors have horror stories of losing big after believing that a company would return to its former glory. Investors should commit money based on future earnings power, not the past. The fact that the EPS number remains constant while the stock prices fluctuate is a problem as well. If a major company event drives the stock price significantly higher or lower, the trailing P/E will be less able to reflect those changes.

How About Both?
Instead of picking one P/E ratio, why not use both? Sometimes the trailing and forward P/E are similar but at other times there may be drastic differences. If they are different, do further research to figure out why. If a company is rapidly growing, the forward P/E could be much higher than the trailing P/E. If it sells a piece of its business or undergoes a large scale restructuring, forward earnings could be drastically lower, temporarily.

SEE: How to Use the P/E Ratio

If the differences between the two numbers are statistically insignificant, what does that say about the growth of the company? Comparing the two numbers will reveal questions worth researching that one number alone may not.

The Bottom Line
The P/E Ratio is one of the most important metrics for determining the value of a company. As the most common, forward P/E and trailing P/E are great indicators, but each has its own drawbacks. So instead of marrying yourself to one or the other, use both as a means of further research.

Related Articles
  1. Investing Basics

    The Basics Of A Financial Analysis Report

    Running financial analysis on a company or industry is a key skill every investor must learn and understand how to undertake without which an ineffective financial report and investment recommendation ...
  2. Fundamental Analysis

    5 Stock Market Metrics Explained

    Learn how to evaluate a company's performance using metrics such as ROE, EPS and P/E ratio.
  3. Active Trading

    5 Must-Have Metrics For Value Investors

    These quick-and-dirty ratios will help you find the most undervalued stocks on the market.
  4. Forex

    The Price To Earnings Ratio Explained

    The price to earnings ratio is one of the most important ratios in investing. Find out how it is calculated, how it can be used and what it tells investors about a particular stock.
  5. Options & Futures

    Profit From Earnings Surprises With Straddles And Strangles

    These option strategies allow traders to play on earnings announcements without taking a side.
  6. Stock Analysis

    Analyzing Microsoft's Return on Equity (ROE) (MSFT)

    Discover a detailed analysis of Microsoft's historical return on equity, and learn how its ROE stacks up to its competitors in the tech industry.
  7. Stock Analysis

    Google's 5 Key Financial Ratios (GOOG)

    Learn how calculating financial ratios such as the debt-to-equity ratio and price-to-earnings ratio helps investors evaluate Google's core business.
  8. Stock Analysis

    Gilead's 3 Key Financial Ratios (GILD)

    Learn about key financial ratios for Gilead Sciences. Read about a large debt offering the company made in the third quarter of 2015.
  9. Stock Analysis

    Top 5 Stocks Listed on the Australian Securities Exchange for 2016 (RIO)

    Uncover five of the stocks listed on the Australian Stock Exchange (ASX) that offer investors the highest potential for above-average profits in 2016.
  10. Fundamental Analysis

    Will Health Care Continue to Drive IPOs in 2016?

    Learn why health care IPOs may be slowing in 2016, and how Obamacare, poor previous filings and economic factors are affecting the health care sector.
RELATED FAQS
  1. When does a growth stock turn into a value opportunity?

    A growth stock turns into a value opportunity when it trades at a reasonable multiple of the company's earnings per share ... Read Full Answer >>
  2. What is Fibonacci retracement, and where do the ratios that are used come from?

    Fibonacci retracement is a very popular tool among technical traders and is based on the key numbers identified by mathematician ... Read Full Answer >>
  3. What is finance?

    "Finance" is a broad term that describes two related activities: the study of how money is managed and the actual process ... Read Full Answer >>
  4. What is the 'Rule of 72'?

    The 'Rule of 72' is a simplified way to determine how long an investment will take to double, given a fixed annual rate of ... Read Full Answer >>
  5. What is the formula for calculating EBITDA?

    When analyzing financial fitness, corporate accountants and investors alike closely examine a company's financial statements ... Read Full Answer >>
  6. How do I calculate the P/E ratio of a company?

    The price-earnings ratio (P/E ratio) is a valuation measure that compares the level of stock prices to the level of corporate ... Read Full Answer >>
Hot Definitions
  1. Harry Potter Stock Index

    A collection of stocks from companies related to the "Harry Potter" series franchise. Created by StockPickr, this index seeks ...
  2. Liquidation Margin

    Liquidation margin refers to the value of all of the equity positions in a margin account. If an investor or trader holds ...
  3. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  4. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  5. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
Trading Center