"Forward P/E"
I've noticed that a lot of reports use the "forward P/E" based on the expected earnings. However, in commentary on chapter 14 of The Intelligent Investor by Ben Graham, Jason Zweig (2003) writes:
"...the prevailing practice on Wall Street today is to value stocks by dividing their current price by something called "next year's earnings." That gives what is sometimes called "the forward P/E ratio." But it's nonsensical to derive a price/earnings ratio by dividing the known current price by unknown future earnings. Over the long run, money manager David Dreman has shown, 59% of Wall Street's "consensus" earnings forecasts miss the mark by a mortifyingly wide margin - either underestimating or overestimating the actual reported earnings by at least 15%. Investing your money on the basis of what these myopic soothsayers predict for the coming year is as risky as volunteering to hold up the bulls-eye at an archery tournament for the legally blind."
Is there anything to be said for the "forward p/e" as a substitute for the plain old kind? Is it not an inherently speculative statistic? And it not wise to study what was actually earned last year before looking at the projected earnings for next year? I'm still learning about security analysis but I'm well convinced by Mr. Zweig's argument.
When you buy a stock, you are buying into the company's future earnings, not past earnings. That's essentially why forward multiples are used.
Learning what happened last year is relevant, but can be misleading. Some sectors are highly cyclical and so they don't follow a straight line model of earnings. Other companies, mostly tech, have negative earnings- if you used "current" multiples, no one would buy into a company with negative earnings.
The author's argument is more about the "accuracy" of equity analysts than the use of forward P/E. But you can't fault honest equity analysts. Predicting earnings is not a simple task and there are a lot of variables that can affect earnings in a given quarter/FY. They try to control for all that but at the end of the day, its still just a best estimate.
how do we valuate highly cyclical stocks?
Yeah, I agree with everything you said.
All I'm saying is that I think the average investor reading the reports would be better off with P/E based on last year's earnings (or maybe the average over the last 3 or 5 years if it's a cyclical business) which he at least knows to be true, than with a statistic which is probably inaccurate. Basically, I think that if I had to choose which P/E value to look at, I would not choose the forward P/E. I'd rather get the one based on facts. But I don't deny that forward P/E can still be a useful statistic for the reasons you described.
Like I said, I've only been studying this for a while, so I might be way off.
This is what I think about forward PEs, its really just my understanding of the concept, I am not in research.
When you divide the current share price by the future earnings estimate, you get your forward PE. But what is more important is estimating what the forward PE should be (based on your estimate of the growth rate of the company), and multiplying your estimated forward PE by your estimated future EPS and you will get what you think the share price should be in the future. If all you are using is historical PE and historical EPS you are really left with no guidance for the future.
Or you could look for companies that are undervalued from past earnings (although you'd have to ascertain the reason they are undervalued - perhaps bleak future prospects)
Impossible is nothing
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