Forward Price-to-Earnings (P/E): What It Is, What It Tells You (2024)

What Is Forward Price-to-Earnings (Forward P/E)?

Forward price-to-earnings (forward P/E) is a version of the ratio of price-to-earnings (P/E) that uses forecasted earnings to calculate the ratio. Although these earnings estimates aren't as reliable as current or historical earnings data, forward P/E analysis may still offer valuable insights to investors.

P/E ratios vary significantly by sector due to differences in growth rates, risk profiles, and capital structures specific to each industry. For instance, regional banks, which tend to have stable earnings, typically have a forward P/E of around 16. In contrast, the healthcare information and technology sector, driven by rapid innovation and higher growth expectations, has a much higher forward P/E of 133.

Forward P/E guides capital market analysts on what to expect in future earning cycles. These expectations influence stock prices, which will adjust based on the actual earnings compared to the forecasts.

Key Takeaways:

Forward P/E is a version of the ratio of price-to-earnings that uses forecasted earnings for the P/E calculation.
Because forward P/E uses estimated earnings per share (EPS), it may produce incorrect or biased results if actual earnings are different.
Analysts often combine forward and trailing P/E estimates, along with other key financial metrics, to make a better judgment.

Understanding Forward Price-to-Earnings (Forward P/E)

The forecasted earnings in the formula below are typically projected for the following 12 months or the next full-year fiscal (FY) period. The forward P/E can be contrasted with the trailing P/E ratio.

$\text{Forward } P/E = \frac{\text{Current Share Price}}{\text{Estimated Future Earnings per Share}}$ ForwardP/E=EstimatedFutureEarningsperShareCurrentSharePrice

For example, assume a company has a current share price of $50 and this year’s earnings per share (EPS) are $5. Analysts estimate that the company's earnings will grow by 10% over the next fiscal year. The company has a current P/E ratio of:

What Does Forward Price-to-Earnings Reveal?

Analysts like to consider the P/E ratio as a price tag on earnings, used to calculate a company's relative value based on its earnings. In theory, $1 of earnings should be worth the same across different companies, but this is rarely the case in practice.

For instance, if Company A trades at $5 per share and Company B at $10 per share, the market values Company B's earnings more. This difference can be interpreted in various ways. For example, it might indicate that Company B's earnings are overvalued or that Company B's superior management and business model warrant a higher valuation.

The trailing P/E ratio compares today's price against earnings for the past 12 months or the last fiscal year, reflecting historical data. In contrast, the forward P/E ratio uses earnings estimates to project the company's future value based on expected earnings.

For example, if the current price of Company B is $10, and earnings are expected to double to $2 next year, the forward P/E ratio would be 5x, indicating the company is valued at half its current P/E ratio. A lower forward P/E ratio compared to the current P/E suggests analysts expect earnings to increase. Conversely, a higher forward P/E ratio indicates expectations of declining earnings.

Forward P/E vs. Trailing P/E

Forward P/E uses projected earnings per share while trailing P/E relies on past performance by dividing thecurrent share priceby the total EPS earnings over the past 12 months. Trailing P/E is the most popular metric because it's objective is to assume that the company has reported earnings accurately. Some investors prefer trailing P/E because they don't trust earnings estimates made by others.

However, trailing P/E has shortcomings, namely, that past performance doesn't guarantee future results. Investors may be better off focusing on future earnings power, rather than past earnings. Another issue with trailing P/E is that the EPS number remains constant while stock prices fluctuate. If a significant event causes the stock price to rise or fall dramatically, the trailing P/E may not accurately reflect these changes.

Limitations of Forward P/E

Since forward P/E relies on estimated future earnings, it can be subject to miscalculation and analyst bias. Companies might underestimate earnings to beat future consensus estimates or overstate them and adjust later. Analysts' estimates can also differ from company estimates, adding to potential confusion.

That's one key reason forward P/E ratios are often cited as indicators of a stock's value, but studies show that trailing P/E ratios are more reliable for predicting future performance.

If you use forward P/E as the central basis of yourinvestment thesis, research the companies thoroughly. Updates to a company's guidance can significantly affect the forward P/E, possibly altering your investment perspective. It’s wise to use both forward and trailing P/E ratios to form a more reliable assessment.

How to Calculate Forward P/E in Excel

Using Microsoft Excel, you can calculate a company's forward P/E for the next fiscal year. The forward P/E formula is the company's market price per share divided by its expected earnings per share.

To set up your Excel sheet:

Increase the widths of columns A, B, and C to 30 by right-clicking on each column, selecting "Column Width," and entering 30.
In cell B1, enter the name of the first company; in cell C1, enter the name of the second company.
In cell A2, enter "Market price per share," then input the market prices for the companies in cells B2 and C2.
In cell A3, enter "Forward earnings per share," then input the expected EPS for the companies in cells B3 and C3.
In cell A4, enter "Forward price to earnings ratio."

For example, assume that Company ABC is currently trading at $50 and has an expected EPS of $2.60:

Enter "Company ABC" into cell B1.
Enter "=50" into cell B2 and "=2.6" into cell B3.
Then, enter "=B2/B3" into cell B4. The resulting forward P/E ratio for company ABC is 19.23.

On the other hand, company DEF currently has amarket valueper share of $30 and has an expected EPS of $1.80:

Enter "Company DEF" into cell C1.
Next, enter "=30" into cell C2 and "=1.80" into cell C3.
Then, enter "=C2/C3" into cell C4, resulting in a forward P/E ratio of 16.67.

Why Might a Forward P/E Ratio Be Higher Than P/E?

If the forward P/E ratio is higher than the current P/E ratio, it indicates that analysts expect the company's earnings to decrease in the future. However, these estimates aren't always accurate and can be subject to revisions.

Why Do Forward P/E Ratios Vary By Sector?

Forward P/E ratios tend to vary by sector due to differences in industry growth rates, risk profiles, and capital structures. The technology sector, for example, often has higher forward P/E ratios because investors anticipate rapid growth and significant future earnings in these industries. Sectors such as utilities often have lower forward P/E ratios since they're viewed as having slower growth potential.

What is Considered a Good Forward P/E?

There is no good forward P/E ratio as it varies by industry. However, a lower forward P/E ratio may indicate a stock is undervalued relative to its future earnings potential.

The Bottom Line

The forward P/E ratio can be a valuable tool for investors, providing insight into a company's future earnings potential relative to its current stock price. But while it can help predict future performance, it's important to also recognize its limitations, including relying on analysts' estimates, which can be inaccurate.

Investors should use forward P/E alongside other metrics, such as trailing P/E, PEG ratio, and book value, to get a comprehensive view. A balanced approach to stock analysis and valuation is your best bet, and consulting an investment professional can provide additional guidance.