If an investor is asked to identify the most popular stock market metric, other than price, price to earnings ratio (P/E) would most likely pass his lips. Not only is the P/E ratio the best-known indicator of an equity’s true value, but it’s also remarkably easy to calculate.
To determine the P/E value, one simply must divide the current stock price by the earnings per share (EPS). The current stock price (P), can be gleaned by plugging a stock’s ticker symbol into any finance website. And although this concrete value reflects what investors must currently pay for a stock, the EPS is a slightly more nebulous figure.
EPS comes in two main varieties. The first is a metric listed in the fundamentals section of most finance sites; with the notation "P/E (ttm)," where “ttm” is a Wall Street acronym for “trailing 12 months.” This number signals the company's performance over the past 12 months. The second 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 expects to earn in the future. These two types of EPS metrics factor into the most common types of P/E ratios: Forward P/E and Trailing P/E.
Forward P/E uses future earnings guidance rather than trailing figures. Sometimes called "estimated price to earnings," this forward-looking indicator is useful for comparing current earnings to future earnings, and helps provide a clearer picture of what earnings will look like—without changes and other accounting adjustments. However, there are inherent problems with the Forward P/E metric. Namely: companies could underestimate earnings in order to beat the estimate P/E when the next quarter's earnings are announced. Other companies may overstate the estimate and later adjust it going into their next earnings announcement. Furthermore, external analysts may also provide estimates, which may diverge from the company estimates, creating confusion.
If you're using Forward P/E as a central basis of your investment thesis, research the companies thoroughly. If the company updates its guidance, this will affect the Forward P/E in a way that might make you revise your opinion.
Trailing P/E relies on past performance by dividing the current share price by the total EPS earnings over the past 12 months. It's the most popular P/E metric because it's the most objective—assuming the company reported earnings accurately. Some investors prefer to look at the Trailing P/E because they don't trust another individual’s earnings estimates. But Trailing P/E also has its share of shortcomings. Namely: a company’s past performance doesn’t signal future behavior. Therefore, 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 also a problem. If a major company event drives the stock price significantly higher or lower, the Trailing P/E will be less reflective of those changes.
How About Both?
Instead of selecting one P/E ratio, why not use both? Sometimes the Trailing and Forward P/E are similar. Other times they’re divergent. If they are different, conduct further research to determine 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 temporarily nosedive.
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 a single number may not.
The Bottom Line
The P/E Ratio is one of the most important metrics for determining the value of a company. And while Forward P/E and Trailing P/E are solid indicators, each has its own drawbacks. Using both as a means of further research will ultimately help you make better investment decisions.