Trailing versus Forward PE Ratio

Introduction - Different P/E Ratios

The lack of consistently reliable and transparent PE Ratio data on the web is the reason I made this website. All too often, websites do not specify which type of PE Ratio they are displaying. In addition, there’s benefits to looking at both as investor expectations and growth assumptions can say a lot about the market or a stock.

Trailing P/E Ratio

The most common PE Ratio published on the web is Trailing PE Ratio. It is a simple statistic because it involves known and agreed upon data. The trailing year of earnings are published in any 10-K or 10-Q. In addition, market capitalization is readily available. While the data collection and calculation are simple, there are accounting nuances to immediately consider.

Say your investment research identifies two great companies within the same industry, and your last step is to decide which one is superior. You notice a considerable difference in Trailing PE Ratios with one company trading at 20 and another 15. If all else were approximately equal, a long-term investment in the company with the lower PE Ratio would be obvious but proceed with caution. Suppose that in the last year, the company with the lower PE Ratio had a stroke of good luck. One of their small and crummy manufacturing facilities happened to be right next to where the city announced a new NFL stadium would be built. The executives of this company moved swiftly, and sold this crummy facility for a nice profit, and reopened shop in a different part of town. Besides from this, their operations remained unimpacted. Also suppose that when reading their annual report, you discover that the profit on this plant sale accounted for 25% of their earnings. So, ask yourself, is including this one-time sale within your PE Ratio comparison fair? Likely not, as the profit from the sale has already shown up on the balance sheet and assuming better earnings potential due to lower PE Ratio assumes they will sell another building for a hefty profit each year. Lastly, let’s adjust 20 downward by 25% to reflect this unusual profit. The answer is 15 or the same as the other company. Be on the lookout for extraordinary items on income statements. They can skew Trailing PE Ratios and give you unreasonable optimism or pessimism.

Forward P/E Ratio

A prior year’s earnings do not guarantee similar earnings in the future. This is an inherent issue with the Trailing PE Ratio which it is based on the past. The future may be different and having a PE Ratio that is forward looking would be beneficial. The challenge with the Forward PE Ratio is that future earnings are uncertain and are not found on a 10-K or 10-Q. Generally future earnings are projections made by key stock analysts who are having constant conversations with company management and researching the market. So, if a Forward PE Ratio is higher than a Trailing PE Ratio, you know that analysts have lowered the future year’s earnings power. If a Forward PE Ratio is lower than a Trailing PE Ratio, you know that analysts have raised the future year’s earnings power. At this point, you should be able to identify the key consideration with Forward PE Ratio, that the future is uncertain. Stock analysts are human and forecasting mistakes are rampant.

Comparing Trailing and Forward P/E Ratio

There will be differences in Trailing PE Ratio and Forward PE Ratio, and these differences share a wealth of information about investor expectations for growth. If a Forward PE Ratio is much lower, a company needs to experience considerable earnings growth to achieve this PE Ratio. We can easily back into this growth assumption by comparing the two:

Assumed Earnings Growth = Trailing PE Ratio / Forward PE Ratio - 1

Let’s do this calculation for the S&P 500 index at the end of 2020. At the end of 2020, the Trailing PE Ratio is approximately 40, but the Forward PE Ratio is about 25. This is a considerable difference and using the above calculation we can see that the assumed earnings growth is nearly 60%. In normal times, most value investors would be screaming absurdity, but it may be likely that 60% is obtainable as we recover lost income due to the pandemic. Time will tell, but a comparison between Trailing and Forward PE ratio tells us a lot. The mention calculation is below:

60% = 40 / 25 - 1

Next Article -- High versus Low PE Ratio

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