Trailing P/E and Forward P/E

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Today I'll be breaking down two commonly used Price to Earnings Ratios (P/E).

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Trailing P/E vs. Forward P/E

Highlights

• The Price to Earnings Ratio (P/E) is a metric that quickly gauges a company’s stock price and its relation to its earnings.

• Trailing P/E is used by investors who prefer the tangibility of earnings results that have already taken place.

• Forward P/E is used by investors who believe that investments should be made on the basis of future earnings.

What Is The Price To Earnings Ratio?

The Price to Earnings Ratio (P/E) is a metric that quickly gauges a company’s stock price and its relation to its earnings. The P/E Ratio is used to assess how much of a premium an investor would be paying to own a stock.

For example, let’s say company XYZ is trading at 25x earnings. That means an investor who buys at this 25x earnings level would be paying $25 for every dollar of earnings company XYZ produces.

Why do stocks trade at an earnings multiple?

Investors invest their money with a company because they want to see their money grow and they believe an ownership stake in a growing company will do just that.

The thing is, some companies are growing faster than others and investors act accordingly.

The more bullish sentiment there is surrounding a stock, the more people buy the stock. The more people who buy a stock, the higher the price becomes.

When the price goes higher, it becomes more detached from the underlying earnings. Therefore, the bullish sentiment drives up the price and the price gets ahead of earnings and trades at a higher p/e multiple.

Trailing P/E

Trailing P/E is calculated by taking a stock’s price and dividing it by the trailing twelve months (TTM) of earnings per share.

Trailing P/E is used by investors who prefer the tangibility of earnings results that have already taken place, rather than speculating about future earning.

One flaw with using Trailing P/E is that past performance does not indicate future results. A stock might look undervalued but just because it’s trading at a low P/E doesn’t mean it’s guaranteed to return to a higher one.

Forward P/E

Forward P/E is calculated by taking the company's stock price and dividing it by the expected next 12 months of earnings per share.

Forward P/E is used by investors who believe that investments should be made on the basis of future earnings.

Some flaws in using Forward P/E are that it uses earnings estimates from company projections or analyst predictions that can both be far off for a number of reasons.

Companies can intentionally underestimate earnings projections to make sure that they beat expectations in the next quarter. They can also adjust earnings projections at any time.

Analyst predictions can vary greatly due to differing estimates of projections, market sentiment, and subjective estimates.

Fortunately, when forward earnings are published, it is done by providing a consensus estimate of an average of the analyst predictions.

Final Thoughts

I began my investing journey only using Trailing P/E because I like how concrete and tangible it is.

I avoided Forward P/E because I’m not a huge fan of when companies undershoot earnings to make sure they reach targets.

However, I’ve come around to using both Trailing P/E and Forward P/E in my research. I’m looking to use metrics that can offer differing perspectives without using so many metrics that my research becomes cloudy.

Some tips I've found to be helpful when using P/E ratios:

• Compare the P/E of a stock you're interested in with the P/E of its competitors

• High P/E ratios don't always mean a stock is overvalued, sometimes a business is really strong and/or growing at a high pace

• Low P/E ratios don't always mean a company is undervalued, sometimes a business has a murky future or it doesn't have many growth prospects

• Take a look at a company's 5-year average P/E ratio to get a sense of where the stock is valued relative to the last 5 years.

P/E ratios whether you use Forward, Trailing, or both, are just the tip of the valuation iceberg.

You can use P/E ratios to get a quick snapshot of a company’s valuation, but you can go much deeper with things like DCF models, which I’d like to cover later.

Links & Memes

The music makes this 10x funnier:

I don't know what this says about my sense of humor but any time the shitty recorder version of the Titanic song is played over a video I laugh my ass off 😂

This is why I can never use a machine at the gym after January 1st:

I've watched this 10 times and still cannot figure out how Klay Thompson got the ball:

I need the backstory on what this dude did to deserve a punishment like this:

Dude is like "Just get me off the fucking field" 😂

Building IKEA furniture be like:

New Episode Of The Dose Of Dividends Podcast!

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Disclosure: The contents of this newsletter are in no way intended to provide financial advice. Dr. Dividend may have positions in any of the stocks mentioned and this newsletter is in no way intended to promote buying or selling of any security. Please do your own research before investing in anything.