If investors want to stop worrying about the uncertainty underlying a company’s future, they should consistently use trailing P/E ratios to screen stocks
Value investors like to search out bargains by sorting stocks into quartiles according to their P/E ratios and then focus on the lowest P/E ratio group. They believe that the lowest P/E stocks, on average, outperform stocks with high trailing P/E ratios. Other investors, however, like to use forward P/E ratios to identify stocks they expect to outperform.
Forward P/E ratios look relatively reasonable compared with historical averages these days, particularly for emerging markets and growth indexes and vis-à-vis trailing P/Es, which do not. Should we all then be running to buy NasdaqNot so fast. My research shows that for some markets, such as the NYSE, forward P/E ratios are a good indicator of future returns.
Why do forward P/E ratios have inferior forecasting ability compared with trailing P/E ratios? The answer is simple. Trailing earnings are based on realized earnings, while forward earnings are based on forecasts by analysts. Analysts tend to be overoptimistic when forecasting earnings. This bias pushes down forward P/E ratios, giving the impression that a stock commands a low P/E when in fact that may not be the case.
But when it comes to the group of stocks with the highest uncertainty, on average, analysts tend to overestimate actual earnings by 21 per cent. These are big errors, hence the inaccuracy of forward P/E ratios, particularly for this group of stocks.
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