When it comes to analyzing stocks determining the correct P/E ratio variation to use is an important part of the process. The current P/E ratio is often the most used, and it compares the earnings over the last 12 months with the current stock price. However, this usually falls short when it comes to analyzing the future earnings of the company because you are just comparing the stock price with the current earnings when the future earnings might be entirely different. This is why the forward P/E ratio is such an important financial ratio to use when analyzing stocks.
What is the forward P/E ratio?
The forward price-to-earnings ratio compares the current stock price with the future expected earnings of the company over the next 12 months. Since the company does not have actual earnings over the next 12 months yet, the forward P/E ratio is calculated based on analysts' consensus estimates for what the company’s earnings over the next 12 months will be.
Forward P/E ratio formula
The forward price-to-earnings ratio is calculated simply by dividing the current share price by the expected EPS over the next 12 months. Here is the formula you can use to calculate it:
Forward P/E Ratio = Current Stock Price / EPS over the next 12 months
Forward P/E ratio example
Let’s consider company XYZ, which has a current stock price of $10 per share, and analysts are estimating that the EPS over the next 12 months will be $1. By simply dividing 10 by 1 you get a forward price-to-earnings of 10.
The importance of the forward P/E ratio
Determining the value of any stock is dependent on the company’s ability to generate earnings in the future. While the current price-to-earnings can be used to evaluate a stock, it falls short when it comes to determining its true valuation.
This is why the forward P/E ratio is such a useful metric because it gives investors a glimpse into the future earnings of the stock and its current valuation based on those expected future earnings. Another simple way of using the forward P/E ratio is by comparing it with the current P/E ratio.
Basically, if a stock has a forward P/E lower than its current P/E, that means that the company’s earnings are expected to increase and that the current valuation, might not be reflective of the future ability of the company to generate earnings. This is one of the main things growth investors look for because they are buying the stock not based on its current earnings, price and valuation but on the future expected earnings of the business. Therefore, they are willing to pay a higher multiple based on the TTM earnings because the multiple will eventually be lower once the company announces higher earnings.
It should also be emphasized that the forward P/E ratio is calculated based on analyst estimates, and therefore because they are just estimates, they may not materialize. Therefore, this is one of the disadvantages of using the forward P/E ratio that we will discuss further.
Advantages of using the forward P/E ratio
Here are some of the main advantages of using the forward price-to-earnings ratio:
- It gives you a glimpse into the future: Stock prices are driven by the future earnings of the company, and when valuing a stock, you want to make sure that the earnings will grow; otherwise, it is likely that the stock price may stay flat or even decline. Therefore, using the forward P/E ratio and comparing it with the current is a simple and fast way to determine whether analysts are predicting the earnings to grow.
- It’s a better way of analyzing the P/E ratio: The forward P/E ratio lets investors analyze the company’s valuation based on its earnings for the future 12 months, which is a lot more accurate than the past 12 months.
- Combine it with the current P/E to see where earnings are going: Combining both the current and forward P/E ratio, investors can have a much broader overview of the company’s future performance and its expected valuation in the coming 12 months.
Disadvantages of using the forward P/E ratio
The forward price-to-earnings ratio also has a few drawbacks, such as:
- It’s solely based on estimates: It is important to note that the forward P/E ratio is solely based on analyst consensus estimates for the company’s earnings over the next 12 months. This does not mean that the company will actually achieve those earnings, and stocks miss their earnings expectations regularly, so be aware of this.
- There’s no guarantee that the company’s earnings will be close to the estimates: Once again, there is no guarantee that the earnings will be like analysts are estimating, and sometimes unforeseen events may affect a company’s earnings.
- You can’t simply use the forward P/E ratio to value a stock: While the forward P/E ratio is extremely useful, it can’t be a single decisive ratio to value a stock or decide whether or not to invest in it. Investors need to look at other metrics and the company’s financial statements to finally make a decision.
What is a good forward P/E ratio?
While we could discuss whether or not a certain forward P/E ratio is good or not, the most important thing is to look for stocks that have a lower forward P/E than their current P/E ratio. The reason is that if this is the case, then the company’s earnings are expected to increase over the coming 12 months, and nothing creates more shareholder value than earnings growth.
With that said, companies that have a single-digit forward price-to-earnings or under 10 are usually some of the best stocks to buy. This is because if the estimates are accurate and the company meets the expected earnings, the stock will be very low priced, and this will drive other investors to buy it, pushing its price higher and making you profit.
It is also crucial for investors to understand that the forward P/E ratio might be lower than the current because the company is simply expected to have a better-performing 12 months. What this means is that companies that can perform better during short periods of time may have a lower forward P/E ratio.
Still, eventually, the earnings after those 12 months may be lower, and the forward P/E ratio after 12 months may be closer to or even higher than the current P/E ratio. Signaling that the company had a short period of 12 months with great earnings, but those will eventually decline.
Should the forward P/E ratio be high or low?
Ideally, investors should focus on stocks with low forward price-to-earnings because these companies are expected to grow their earnings, and therefore their stock prices are also expected to increase if those earnings estimates materialize.
This is usually one of the best ways to look for stocks based on the P/E ratio, and you can easily set up a stock screener that lets you look for stocks whose forward P/E ratio is lower than the current P/E ratio to find some undervalued stocks that are worth analyzing.
The P/E ratio remains one of the most important stock metrics to analyze, and it allows you to easily and quickly determine whether a stock is worth researching or not. However, it is important to be aware of the limitations and drawbacks of using this simple financial metric to make investment decisions, and while it is extremely useful, it cannot be the sole foundation of your stock research strategy.