A: The price-to-earnings ratio or P/E ratio must be the most frequently quoted, and abused, stock valuation tool.
Both investing amateurs and professionals like to toss out references to a stock's P/E as a gauge of whether it's cheap or expensive. But as you point out in your question, a stock's P/E can be measured in many ways, and the method you choose dramatically changes the conclusion.
I won't get into how many variations of the P/E there are. If you're interested in learning more about forward and trailing P/Es, and the advantages and disadvantages of each, you can read in the 'Quote' box below.
The price-to-earnings ratio (P-E) holds great mystique for many investors. But it's really just a division problem.
A stock's price-to-earnings ratio is its share price divided by its earnings-per-share. Everyone can agree on the share price, since that's readily available and quoted in real time on a stock exchange. It's the denominator investors disagree over, and the number you choose can create the dramatic effects on the P-E ratio that you're noticing.
There are two popular ways of handling this. One is to use earnings from the past, or "trailing" twelve months, as the denominator. This trailing P-E is the most conservative because the earnings are official, and in the books.
Others prefer to use expected, or "forward" earnings, for the current year as the denominator. They argue earnings from the past twelve months are ancient history. And they point out that most companies beat earnings estimates anyway, making forward earnings also a pretty conservative benchmark.
The difference between the trailing and forward P-E, as you've found, can be huge, especially for a company that's growing or shrinking dramatically. In most cases, earnings for the trailing twelve months are lower than the forecasted earnings. When that's the case, the trailing P-E will be higher than the forward P-E.
But your case is the opposite. That means analysts are expecting the company's earnings to be dramatically lower in the next 12 months than they were in the past 12 months.
Let's use an example. Imagine a stock trading for $50 a share that earned $15.15 a share in the past 12 months and is expected to earn 48 cents a share in the coming 12 months. That's a 97% decline in earnings. If you do the math and divide $50 by $15.15, you see the stock has a 3.3 trailing P-E. And if you divide the same $50 stock price by the 48 cents expected earnings, you see a forward P-E of 104.
Is this good or bad? On its face, it looks bad because earnings are falling so much. But you'll want to research the company and find out why earnings are expected to fall so precipitously. There may be a good reason for it, such as the divestiture of a major business unit or other corporate restructuring.
The forward P/E is based on what the company is expected to earn a year in the future. And the trailing P/E is based on what the company earned in the previous year. The difference between a trailing and forward P/E can be dramatic.
Which P/E should you pay attention to? The answer is, both. It's especially important now to consider both because future earnings are so unpredictable.
Rather than trying to pick which P/E ratio to use, compare them with each other. If you see a big difference between the two, you might learn more about the company's valuation if you find out why the forward and trailing P/E are so different.
For instance, if you notice that a stock has a high double-digit trailing P/E and a low forward P/E, you know that analysts are predicting earnings to recover sharply, but investors aren't believing the estimates yet. In that situation, if the company delivers as analysts hope, there could be a nice upside for the stock.
Similarly, if a stock's trailing P/E is low but the forward P/E is high, it might be a clue that analysts are being extremely bearish about the company's future, which might be a warning to you. On the other hand, this situation might mean investors are being overly optimistic about a stock's future, and they could be in for a rude awakening.
As you see, there's great value in looking at both the trailing P/E and the forward P/E.
Source: Edited articles of Matt Kranzz
http://usatoday30.usatoday.com