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There’s a certain ease of use that comes with the quotation of a Price-to-Earnings ratio (P/E). On television, in print or with friends at the country club, the P/E ratio is frequently used as the sole data point to justify whether an investment is cheap or expensive, and thereby inferred to be predictive of upcoming price movements in the stock market. The beauty of the P/E ratio is the figure is easy to calculate and it makes intuitive sense. In the numerator is the price of the stock market index or one share of stock today. In the denominator, the amount of earnings per share the combined market or company is expected to generate in the future or generated in the past (usually a 12-month look-ahead or look-behind window). Comparisons are easy, too. If one could buy $1 of earnings for $10 (a P/E ratio of 10) in Company A, why would one buy shares of Company B for $16 with the same $1 of earnings (a P/E ratio of 16)?
Already, a potential spot for disagreement is apparent. A trailing P/E ratio has a high level of certainty embedded in the metric because the ‘E’ is sourced from financial reports with concrete numbers. But stock prices are a reflection of future expectations, meaning a trailing 12-month P/E ratio can have limited value when it comes to predictive power. Enter the forward P/E ratio. Using individual, expert or consensus estimates to predict future earnings per share results, the denominator is improved by matching the forward-looking price with a forward-looking earnings figure. Of course, there is a tradeoff. Estimates seek to predict the future, introducing an element of uncertainty not found in the trailing version of the metric.