Forward PE: Why It Is Important Than Standard PE Ratio

forward-pe-ratio

Do you know forward PE ratio is an overlooked metric yet very significant? Some analysts believe it is even more important than standard PE for several reasons. In this post you will learn what is forward PE, how it is different from standard PE.

To understand forward PE, you should know in detail about standard PE in first place. You already know PE stands for Price to Earnings ratio and is calculated by dividing share price (price of each share) a company by its earnings per share (EPS). And below is the formula analysts use to arrive at PE value.

Standard PE = Share Price / Earnings Per Share (EPS)

In the above formula, Earnings Per Share is based on past performance of a company. This is often called yearly EPS because it is based on past 4 quarter earnings of a company.

Since Standard PE is based on past year earnings of a company, it is also called trailing PE.

How To Calculate Forward PE Using Forward Earnings

Below is the formula for forward PE. (Don’t miss to see the minor difference between standard PE formula and this one.)

Forward PE = Share Price / Forward Earnings Per Share

In the above formula, everything is same as in formula for standard PE but with one exception. In this formula, the denominator refers to the future projected earnings or forward earnings of a company. Analysts usually estimate earnings for upcoming 4 quarters. This estimate helps them to calculate future EPS. Using this future EPS value, they will compute forward PE.

How To Interpret Forward Price To Earnings Ratio

You can understand forward PE better by knowing the difference in interpretations of trailing and forward PE ratios.

First let us start with the interpretation of PE.

Consider a hypothetical company that has earned 1000$ in last 4 quarters. Assume that the company has issued 100 shares. The earnings per share (EPS) for past full year is calculated as follows.

EPS for past full year = Past 4 quarter earnings / Number of shares
= 1000$/100 shares
= 10$ per share

Assume that the current share price (per share) of the company is 200$. Now you can calculate the PE as shown below.

Price to Earnings (PE) = Market price of each share / EPS for past full year
= 200$/10$
= 20

What does PE value 20 indicate? This value indicates that if you want to buy shares of the company today, you are are will be spending 20$ for every 1$ earned (in the past) by the company.

If you look at PE of a company in isolation, you cannot say much about the share price of the company. But in general, a low PE value is good. This means, you are going to pay lesser for every dollar earned. Historically, analysts believe a PE value in the range of 10 to 20 is good.

PE gets its real power when you compare two companies. After comparing PE values of two companies of same or similar type of industry, you can easily say which is potentially a better buy.

For example, assume that are two companies A and B (belonging to the same industry). Let A’s PE ratio be 30 and B’s ratio be 20. Quite obviously, B is a better buy compared to A. This is because, if you buy B, you will be spending 20$ for every 1$ earned. But in case of A, you will be spending 30$ for every 1$ earned.

There there are few precautions, which you should keep in mind before comparing PE values of two companies. You will see those points after you look at the interpretation for forward PE.

Below example will help you to learn to interpret forward PE.

Consider a company with a share price of 200$. Assume that the company’s past full year earnings is 1000$. In forward PE, you are not interested in past year earnings. Let a group of esteemed analysts do projections for future performance of the company. Assume that they estimate that the company will make a net income of 2000$ in the following year. Assume that the number of shares is 100.

Now, Forward EPS = Estimated earnings of upcoming year / Number of shares
= 2000$/100
= 20$ per share

The above value indicates that the company is estimated to earn 20$ per share in the upcoming year.

Now, you can calculate forward PE as shown below

Forward PE = Market price of each share / Forward EPS

If the market price of each share is 200$, you can measure forward PE as shown below.

Forward PE = 200$/20$ = 10

Forward PE value of 10 indicates that if you buy shares today, you will be paying 20$ per 1$ (one dollar) of future potential earnings of the company.

Is forward PE ratio more important than standard PE?

Some analysts believe forward PE is a much indicator that PE for the following reason.

  1. You are investing for future returns. Hence, you should base your investment decisions based on future earnings of the company.
  2. Trailing PE may not give correct picture of the company’s future performance. For example, if a company just bounced back from a bad patch, its future PE may be much lesser (even closer to 20 mark) than current PE. Trailing PE will not indicate the recent developments which could increase earnings in future. Some developments in the company which trailing PE could miss include:
    • Changes in management team. For example, the board could have brought in a new CEO with great track record
    • Recent price changes of fuel, raw materials, etc. (Here we are presuming that the fuel costs will remain low for upcoming year and will lead to increased margins for the company)

Are there drawbacks to forward PE

Just as there are arguments for forward PE there are arguments against as well. Some of those arguments are given below.

  1. Value investors usually insist that forward PE should not be taken at face value. This is because future can never be predicted with hundred percent accuracy.
  2. Future estimates of earnings are done by company appointed analysts or independent analysts. In fact, multiple forward PEs will exist for a company at any given time. Existence of multiple forward PEs is a problem and source of confusion for investors.
  3. Though analysts take care of every factor possible, there could be biases and estimation errors.

Is Forward PE Accurate?

Analysts consider a variety of factors before arriving at projected PE. For example, they will not only look at a company in isolation, but will consider the entire industry. For example, if health care sector is expected to grow dramatically in next few years, the analysts will be inclined to give higher EPS and hence lower forward PE ratios for health care companies compared to other low growth sector companies.

Where You Can Find Forward Price To Earnings Ratio?

You can find forward PE in price charts that are displayed in all major finance websites like Nasdaq, Yahoo Finance, etc.

Forward PE ratios exist not only for companies but also for Indexes. It is important to note that, forward PE is not only available for individual companies, but can also exist for index as a whole.

One popular metric traders often look for is S&P 500 forward PE.

What is S&P 500 forward PE?

You already know S&P 500 is a stock market index and there are 500 companies being listed and traded. Analysts project future combined earnings of all these companies to arrive at what is called S&P 500 forward PE.

Using S&P 500 forward PE, you can get a broader perspective of the future earnings of the companies listed. This will help you to decide your overall investment strategy. For example, if forward PE is fairly low (say at levels around 15), you can say market will probably remain healthy in upcoming year. If that is the case, the market will be expected to remain fairly stable without too much ups and downs.

So, What Is Your Takeaway?

Though forward PE can be an outstanding metric, it should be used cautiously. Historically there have been several discrepancies between forward PEs and real performances. Hence, you should use forward PE as only one of several other metrics before deciding to buy a particular stock.