Question

KNOWLEDGE CHECK The below EQRV screen was captured before the markets opened on April 29, 2019. According to rhe informarion shown, is Goldman Shachs trading rich or cheap on a blended forward P/E basis, relative to its historical avarage?

Answer 1

1. First understand basics

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 for the P/E calculation. While the earnings used in this formula are just an estimate and not as reliable as current or historical earnings data, there is still benefit in estimated P/E analysis.
• P/ E = current share price ÷ estimated future earning per share

1. For example, assume that a company has a current share price of $50 and this year’s earnings per share 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 $50 / 5 = 10x.
2. The forward P/E, on the other hand, would be $50 / (5 x 1.10) = 9.1x. Note that the forward P/E is smaller than the current P/E since the forward P/E accounts for future earnings growth relative to today's share price.

2.

What Does Forward Price-to-Earnings Reveal?

• Analysts like to think of the P/E ratio as a price tag on earnings. It is used to calculate a relative value based on a company's level of earnings. In theory, $1 of earnings at company A is worth the same as $1 of earnings at company B. If this is the case, both companies should also be trading at the same price, but this is rarely the case.

• If company A is trading for $5, and company B is trading for $10, this implies that the market values company B's earnings more. There can be various interpretations as to why company B is valued more. It could mean that company B's earnings are overvalued. It could also mean that company B deserves a premium on the value of its earnings due to superior management and a better business model.
• When calculating the trailing P/E ratio, analysts compare today's price against earnings for the last 12 months, or the last fiscal year. However, both are based on historical prices. Analysts use earnings estimates to determine what the relative value of the company will be at a future level of earnings. The forward P/E estimates the relative value of the earnings.

2. For example, if the current price of company B is $10, and earnings are estimated to double next year to $2, the forward P/E ratio is 5x, or half the value of the company when it made $1 in earnings. If the forward P/E ratio is lower than the current P/E ratio, this implies that analysts are expecting earnings to increase. If the forward P/E is higher than the current P/E ratio, analysts expect a decrease in earnings.

3. DIFFERENCE BETWEEN

Forward P/E vs. Trailing P/E

• Forward P/E uses projected EPS. Meanwhile, trailing P/E relies on past performance by dividing the current share price by the total EPS earnings over the past 12 months. Trailing P/E is the most popular P/E metric because it's the most objective—assuming the company reported earnings accurately. Some investors prefer to look at the trailing P/E because they don't trust another individual’s earnings estimates.

• However, trailing P/E also has its share of shortcomings—namely, a company’s past performance does not signal future behavior. Investors should thus commit money based on future earnings power, not the past. The fact that the EPS number remains constant while the stock prices fluctuate is also a problem. If a major company event drives the stock price significantly higher or lower, the trailing P/E will be less reflective of those changes.

4. Limitations of Forward P/E

• Since forward P/E relies on estimated future earnings, it is subject to miscalculation and/or analysts' bias. There are other inherent problems with the forward P/E also. Companies could underestimate earnings to beat the consensus estimate P/E when the next quarter's earnings are announced.

• Other companies may overstate the estimate and later adjust it going into their next earnings announcement. Furthermore, external analysts may also provide estimates, which may diverge from the company estimates, creating confusion.

• If you're using forward P/E as the central basis of your investment thesis, research the companies thoroughly. If the company updates its guidance, this will affect the forward P/E in a way that might cause you to change your opinion. It is good practice to use both forward and trailing P/E to come to a more trustworthy figure.

5. How to Calculate Forward P/E in Excel

• You can calculate a company's forward P/E for the next fiscal year in Microsoft Excel. As shown above, the formula for the forward P/E is simply a company's market price per share divided by its expected earnings per share. In Microsoft Excel, first increase the widths of columns A, B, and C by right-clicking on each of the columns and left-clicking on "Column Width" and change the value to 30.

• Assume you wanted to compare the forward P/E ratio between two companies in the same sector. Enter the name of the first company into cell B1 and the name of the second company into cell C1. Then:

• Enter "Market Price per Share" into cell A2, and the corresponding values for the companies' market price per share into cells B2 and C2.
• Next, enter "Forward Earnings per Share" into cell A3, and the corresponding value for the companies' expected EPS for the next fiscal year into cells B3 and C3.
• Then, enter "Forward Price to Earnings Ratio" into cell A4.

3. For example, assume company ABC is currently trading at $50 and has an expected EPS of $2.60. Enter "Company ABC" into cell B1. Next, 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 a market value per 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. The resulting forward P/E for company DEF is 16.67.

• Since company ABC has a higher forward P/E ratio than company DEF, this indicates that investors expect higher earnings in the future from company ABC than company DEF.

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Related Terms

• Trailing Price-To-Earnings (Trailing P/E) Definition
• Trailing price-to-earnings (P/E) is is calculated by taking the current stock price and dividing it by the trailing earnings per share (EPS) for the past 12 months. more

Price-to-Earnings Ratio – P/E Ratio

• The price-to-earnings ratio (P/E ratio) is defined as a ratio for valuing a company that measures its current share price relative to its per-share earnings. more

Forward Earnings

• Forward earnings are an estimate of a company's next period's earnings, usually to the end of the current fiscal year, sometimes to the following year. more

Dividend Payout Ratio Definition

• The dividend payout ratio is the measure of dividends paid out to shareholders relative to the company's net income. more

Why the Price/Earnings-to-Growth Ratio Matters

• The price/earnings-to-growth (PEG) ratio is a company's stock price to earnings ratio divided by the growth rate of its earnings for a specified time period. more

What Is a Price Multiple?

• A price multiple is any ratio that uses the share price of a company in conjunction with some specific per-share financial metric for a valuation measure.