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.
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 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 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.
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.