The price-to-earnings ratio (P/E ratio) compares the share price of a company to the earnings it generates per share. The formula used to calculate this ratio simply divides the market value per share by the earnings per share (EPS). The typical calculation of the P/E ratio uses a company's EPS from the last four quarters.

A variation on this calculation is known as the forward P/E. Investors or analysts may use projected earnings per share, meaning the earnings expected to be generated per share over the next 12 months. This variation is also known as the leading or projected P/E. The significant difference is the forward P/E is based on analyst speculation about a company's future or forward earnings rather than historical data.

Key Takeaways

  • A variation of the price-to-earnings ratio (P/E ratio) is the forward P/E ratio, which is based on a prediction of a company's future earnings.
  • Earnings used in the forward P/E ratio are estimates of future earnings, while the standard P/E ratio uses actual earnings per share from the company's previous four quarters.
  • The forward P/E ratio can be seen to represent the market's optimism for a company's prospective growth.
  • Limitations of using forward P/E for investment analysis include a company inaccurately estimating expected earnings and model risk caused by programming or data errors.
  • For a better picture of a company's potential as an investment, it's best to combine forward P/E with other ratios such as trailing P/E.

The Difference Between P/E Ratio and Forward P/E

The theory behind a stock's P/E ratio is it provides an estimate of the amount an investor is willing to pay per dollar generated in earnings. The P/E ratio also accounts for company growth expectations in the market. While there are various forces that move a stock's price, the price is ultimately a reflection of what investors think a company is worth. The P/E ratio helps investors assess the attractiveness of a company as an investment by indicating if the company is currently undervalued or overvalued.

The forward P/E ratio should be considered more in terms of the optimism of the market for a company's prospective growth. A company with a higher forward P/E ratio than the industry or market average indicates an expectation the company is likely to experience a significant amount of growth. If a company's stock fails to meet the high ratio value with increased per share earnings, the price of the stock will fall.

Ultimately, the P/E ratio is a metric that allows investors to determine how valuable a stock is, more so than the market price alone. The P/E ratio and forward P/E ratio are particularly helpful when comparing similar companies within the same industry. 

Calculating a Company's Forward P/E

The forecasted earnings used in calculating a forward P/E are usually either projected earnings for the upcoming 12 months or the next full fiscal year. Many companies will provide earnings guidance when presenting their quarterly or annual earnings reports.

Earnings guidance is simply management's comments on what they expect the company will do in the future, focusing on earnings estimates for the upcoming quarter or year. Analysts can either use these numbers provided by a company's management or combine them with their own research to develop their own earnings forecasts.

To calculate a company's forward P/E, divide the current share price by the estimated future earnings per share. Many investors use an Excel spreadsheet to calculate a company's forward P/E and to compare the forward P/E ratios of multiple companies within the same industry

Limitations of Using Forward P/E

While forward P/E can provide an investor with useful information when analyzing a company as a potential investment, it also has several limitations. One limitation is that a company's estimation of expected earnings could be wrong. If actual earnings come in significantly higher or lower, the forward P/E results will be inaccurate.

There's the possibility the company's management could underestimate future earnings in order to beat the consensus estimates. Additionally, they may periodically need to adjust their earnings estimates in response to new data or changing market conditions. This could then render a forward P/E calculation obsolete, requiring a new calculation for a better representation of a company's value. Analysts may come up with their own forward P/E estimates, which could be miscalculated or subject to model risk due to programming or data errors.

Rather than relying on just one metric to support your investment analysis, it's prudent to consider several factors. Many investors review both forward and trailing P/E estimates along with a review of a company's financial statements before making an investment decision.