What is the Forward Price-to-Earnings Ratio (Forward P/E)?
The forward price-to-earnings ratio (forward P/E) is a valuation method used to compare a company’s current share price to its expected per-share earnings.
How Does the Forward Price-to-Earnings Ratio (Forward P/E) Work?
The market value per share is the current trading price for one share in a company, a relatively straightforward definition. However, earnings per share (EPS) may not be as intuitive for most investors. The more traditional and widely used version of the EPS calculation comes from the previous four quarters of the price-to-earnings ratio, called a trailing P/E. Another variation of the EPS can be calculated using a forward P/E, estimating the earnings for the upcoming four quarters. Both sides have their advantages, with the trailing P/E approach using actual data and the forward P/E predicting possible outcomes for the stock. Calculated as the following;
Forward Price-to-Earnings Ratio (P/E) = Market value per share / Forward Earnings Per Share (EPS)
Let’s do a sample calculation with company XYZ that currently trades at $100 and has expected earnings per share (EPS) of $5. Using the previously mentioned formula, you can calculate that XYZ’s forward P/E is 100 / 5 = 20.
Why Does the Forward Price-to-Earnings Ratio (Forward P/E) Matter?
The forward price-to-earnings ratio is a powerful, but limited tool. For investors, it allows a quick snapshot of the company’s finances without getting bogged down in the details of an accounting report.
Let us use our previous example of XYZ, and compare it to another company, ABC. Company XYZ has a forward P/E of 20, while company ABC has a forward P/E of 10. Company XYZ has the highest forward P/E ratio of the two and this would lead most investors to expect higher earnings in the future than from company ABC (which possesses a lower forward P/E ratio).
As noted earlier, all P/E ratios are limited. They do not paint the entire picture for the investor; rather P/E is a complementary tool in your financial toolbox. Forward EPS measures are particularly perilous because they are matters of prediction and are only estimates of projected earnings.
