Should you use earnings forecasts?

John Stepek compares forward to trailing price/earnings ratios to see which is best for valuing shares.


You can't rely on the soothsayers
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The price/earnings ratio (p/e) is one of the simplest and most popular valuation measures in investment. To calculate it, you take a company's share price and divide it by the earnings per share. In effect, it shows how much investors are willing to pay for a given £1 or $1 of earnings from that company. A high p/e indicates that the share is highly valued usually because investors expect earnings to grow quickly while a low p/e suggests the stock is cheap.

But which earnings figure should you use? One option is the "trailing" earnings the most recent full-year profit figure. On the one hand, this has the benefit of being a known figure. On the other, there's no guarantee it will reflect future earnings. So forward p/e ratios where the "e" is based on analysts' forecasts for the year ahead (or even further forward) are often used instead of trailing earnings. These give you a view on how cheap or expensive a firm is compared to what analysts expect its earnings to be but clearly, these forecasts can be wrong.

So which p/e is best? Last year, Joachim Klement of the CFA Institute produced what he reckons is a definitive answer. He looked at four major stockmarket indices: the S&P 500 in the US, theFTSE 350 in the UK, the Euro Stoxx 300 in the eurozone, and the Nikkei 225 in Japan. For each market he took the 20% of stocks with the lowest p/es, and the 20% with the highest, then compared average returns going back monthly over 20 years. He did this for both trailing and forward p/es.

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To cut a long story short, Klement found that investing with the help of trailing p/es was far more effective than using forward p/es across all four major developed markets. Using trailing p/es, the least expensive stocks outperformed the most expensive by anything from 1.2% a year (in the US) to 10.1% (in the UK). Using forward p/es, the least expensive stocks still outperformed the dearest in the UK, Japan and the eurozone, but by a much lower margin than using trailing p/es. And in the US, the cheapest stocks by forward p/e actually did worse than the most expensive ones "in other words, relying on forward p/e ratios destroyed performance", as Klement puts it.

The fundamental problem, says Klement, is that analysts' earnings forecasts are overoptimistic on average by about 10% (although the figure is not consistent enough to be useful in "discounting" this optimism). As a result, even though they're not perfect, you are far better off using trailing earnings to find cheap stocks. In short, says Klement, "Never use forward p/e ratios. Ever."

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.