 Personal Finance Powerpoint Presentation, Forward Price to Earnings, Forward PE. Prepare to get financially fit by practicing personal finance. Most of this information comes from Investopedia, Forward Price to Earnings, Forward PE, which you can find online. Take a look at the references, resources, continue your research from there. This is by Adam Hayes, Update of July 16, 2022. In prior presentations, we've been looking at investment goals, investment strategies, investment tools, keeping in mind the two major categories of investment. That being the fixed income, typically bonds, and then the equities, typically the common stock. We're focused here on the common stock more when we're thinking about the forward PE, forward price to earnings. Also, keep in mind your investment strategies and investment tools. For example, if you were to be investing for a long time horizon, possibly for retirement, you might be using tools such as mutual funds or ETFs to help pool your investments together and help to diversify in which case you might not be scrutinizing so much on individual stocks, but possibly more on sectors and possibly indexes. When we're thinking about individual stock trading, we're going to be scrutinizing doing ratio analysis more likely on those individual stocks, which we might be using tools for such as the forward PE. Keep in that mind, what is forward price to earnings, forward PE? Forward price to earnings, forward PE is a version of the ratio of price to earnings, PE that uses forecasted earnings for the PE calculation. So we're forecasting into the future. That means kind of like we're projecting out into the future. Possibly the reason for doing that is because we want to make the decision on the margin. We want to make the decision going forward. The past data is useful and good mostly because it's more accurate. We know what happened in the past, but if we can have an accurate prediction into the future, that might be more useful for us to try to make investments going forward from this point on the margin as economists say. While the earnings used in this formula are just an estimate and not as reliable as current or historical data, there are still benefits to estimated PE analysis. So in other words, the prior data of course is more reliable because it has actually happened. We know what it is, but we can also try to use projected or future data which might have more predictive power. So understanding forward price to earnings, forward PE, the forecasted earnings used in the formula below are typically either projected earnings for the following 12 months or the next full year fiscal, fiscal year period, which might be different some other 12 month period typically. So the forward PE can be contrasted with the trailing PE ratio. So the forward PE, we've got the current share price. So we're still using the share price at this point in time. That's going to be the market price determined by good old supply and demand. And then we've got that divided by the estimated future earnings per share. So instead of looking at the earnings per share based on the data that has already happened, we're calculating the future earnings per share. For example, assume that a company has a current share price of $50, so it's selling on the market for $50. You could buy this stock for 50 bucks if you want. And this year's earnings per share are $5. Analyst estimate that the company's earnings will grow by 10% over the next fiscal year. The company has a current PE ratio of $50 divided by 5 or 10X. That's the current PE, meaning the $50 is what is being paid for it. And the earnings for each individual share, the earnings per share is 5. So we're at 10X, the price is 10 times the earnings per share. The forward PE on the other hand would be we're going to get to that 9.1X instead of the 10X by taking the 50 divided by the 5 times the 1.1. Because we determined that the growth, it's expected to grow by the 10%. So once again, analysts estimated that the company's earnings will grow by 10%. So if we had the current $5 on an earnings per share basis, we think it's going to grow by 10%, then we can multiply it times 100% plus 10%, 110% or 1.1. And therefore we're going to have the denominator not at 5, but 5 times the growth, therefore 5 times the 1.1. That's what's going to give us that 9.1X instead of the 10X. So note that the forward PE is smaller than the current PE since the forward PE accounts for future earnings growth relative to today's share price. So note we're currently using today's price. You would expect that if there were to be growth, maybe the share price will grow in the future. We're using the same share price and then on the denominator, the earnings per share side of things, instead of keeping that constant at using past data, we're projecting that out into the future. And if we think earnings are going to increase in the future, that means the forward or future earnings per share is going to be higher, which is going to result in a lower forward PE as compared to the current PE. So what does forward price to earnings ratio reveal? Analysts like to think of the PE ratio as a price tag on earnings. So when we're investing, we're trying to generate earnings clearly. We're trying to generate earnings by either getting dividends in the future or we're going to have growth in the company, which we would expect would mean the valuation of the stock would increase. The way that happens, of course, is the company generates revenue. It makes money on what they have on the assets that they have. It makes revenue and either gives that revenue to us in the form of dividends or they reinvest that money into the company, which we would expect gives value to the company increasing the stock price. So it is used to calculate a relative value based on a company's level of earnings. In theory, $1 of earnings at a 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. So it could just mean that for whatever reason just a sentiment on the market is overvaluing company B. If that were the case, then we would expect that possibly to even out over time valuations for the market being reflected in price over time, which could drive our decision making process. If that's our interpretation, it could also mean that the company B deserves a premium on the value of its earnings due to superior management and better business model. So it could also be that there is actual value that the market perceives and the price is being accurately reflected. So notice whenever we do these calculations, it's not just that we look at the ratio. We do the comparison and then we make the decision just mechanically based on whatever the outcome of the ratio analysis will be. Then we have to explain the rationale. Well, why would that be the case? What is the rationale behind that? That's what usually is going to be driving our actual decision making our investments. When calculating the trailing PE 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 are using earnings estimates to determine what the relative value of the company will be at a future level of earnings. The forward PE estimates the relative value of the earnings. For example, if the current price of a company B is $10 and the earnings are estimated to double next year to $2, the forward PE ratio is 5x or half the value of the company when it made $1 in earnings. So notice if there's going to be a substantial growth in the future that we think that the growth is going to go up a lot. That's going to have a lot of an impact or difference between the current PE and the forward PE ratio. If the forward PE ratio is lower than the current PE ratio, this implies that analysts are expecting earnings to increase. So one of the things that could account for people having a higher price, even though we're looking at current PE ratios that are similar in nature, would be that the forward PE ratios are different due to differentiations in future earnings projections. So if the forward PE is higher than the current PE analysts are expecting a decrease in earnings. Forward PE versus trailing PE. Forward PE uses projected earnings per share. Meanwhile, trailing PE relies on past performance by dividing the current share price by the total earnings per share earnings over the past 12 months. We're usually looking at 12 month time periods notes. Trailing PE is the most popular PE metric because it's the most objective of suing the company reported earnings accurately. So trailing PE is useful because the past has already happened. And therefore we can be reliant on that number as long as we can be reliant on the company fairly representing or reporting that number, which hopefully we can be given the fact that they're publicly traded companies, they're being audited and all that kind of stuff. So some investors prefer to look at the trailing PE because they don't trust another individual's earning estimates. So in other words, if we look at forward PE, we got to depend on estimates and whose estimates are we going to trust. Management, they seem a little bit biased possibly, although they could be accurate estimates. Whose analysts are we going to trust going forward that are going to be good? Maybe our best bet is to look at the prior data, which is actually hard data, which has actually happened, even though it's past data and not projected data and then try to figure our own projections. So however, trailing PE also has its share of shortcomings, namely a company's past performance does not signal future behavior. So we could think that the company is going to be fairly consistent going forward or we can try to use that past data and then think about the future. But obviously it would be best if we knew the future. So investors should thus commit money based on future earnings power, not the past. The fact that the EPS earnings per share 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 PE will be less reflective of those changes. Limitations on forward PE. Since forward PE relies on estimated future earnings, it is subject to miscalculation and or analysts biased. So we could mess up what we think the future is going to be, of course. And obviously when we're getting future projections from people, those projections, even if they're analysts that are not within the company, they could be biased on their own because they're trying to rationalize their own decision making process. So everybody's going to have their own take on things. So there are other inherent problems with the forward PE also. Companies could underestimate earnings to beat the consensus estimated PE when the next quarter's earnings are announced. Other companies may overestimate 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. So the company, you might look at the company estimates, but obviously the company in and of itself has its own incentives. One incentive is they don't want to overestimate on one hand because if they overestimate and they don't hit their target, they're going to look bad. So maybe they actually underestimate their estimates on purpose so they have a low hurdle that they can clear. That's one strategy that companies might take sometimes or sometimes they might try to overestimate their estimate, possibly in a way to try to drive market sentiment in such a way that it will actually result in a virtuous cycle. You know, an increase in the stock price artificially. Also, of course, we could have other people calculating what the future value will be outside of the company, which means now you've got multiple kind of future valuations, so which one's the one you need to use. So if you're using forward PE as a central basis of your investment theses, I'll research the companies thoroughly. If the company updates its guidance, this will affect the forward PE in a way that might cause you to change your opinion. It is good practice to use both forward and trailing PE to come to a more trustworthy figure. How to calculate the forward PE in Excel? So we might do some of these in Excel, but you can calculate a company's forward PE for the next fiscal year in Microsoft Excel as shown above the formula for the forward PE is simply a company's market price per share divided by its existing earnings per share in Microsoft Excel, first increase the widths of column A, B, and C by right clicking on each of the columns and left clicking column width. Assume you wanted to compare the forward PE ratio between two companies in the same sector, enter the name of the first company and sell B1 in the name of the second and C1, then enter market price per share into cell A2 and the corresponding values for the company's market price per share into cells B2 and C2, next enter forward earnings per share into cell A3 and the corresponding value for the company's expected earnings per share for the next fiscal year into cells B3 and C3 and then enter forward price and earnings ratio into cell A4 for example, assume company ABC is currently trading at $50 and has an expected earnings per share EPS of $2.6 $2.60 enter company ABC into cell B1, next enter 50 into cell B2 and 2.6 into cell B3 then enter equals B2 divided by B3 into cell B4 the resulting forward PE 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 earnings per share of 1.8 enter company DEF into cell C1, next enter 30 into cell D2 and 1.8 into cell D3 then enter equals C2 divided by C3 into cell C4 the resulting forward PE for company DEF is 16.67