Joseph G. Haubrich, Sara Millington, and Brendan Costello

The price of a stock and its earnings per share allow investors to evaluate the growth potential of individual companies. These two pieces of information can be combined to produce ratios that track the relative valuation of companies over time. One popular metric is the price-to-earnings ratio (P/E ratio). When a P/E ratio is high, it is often a signal that either prices or earnings will change to bring the ratio back toward its average. Some people use the ratio to see if a stock is overvalued, if they think the price is too high to be supported by the earnings. We look at couple variants of the P/E ratio and compare the kinds of information each provides.

The P/E ratio is computed by dividing the current stock price of a company by some measure of its earnings. The ratio can be calculated in two ways: forward or trailing. The trailing P/E ratio uses a company’s historical earnings data, while the forward P/E ratio uses an estimate of future earnings. (Specifically, the forward PE uses analysts’ consensus earnings forecast for the next 12 months.) Since the forward P/E ratio uses projections of future earnings, it has the advantage of looking at expected earnings, rather than current earnings, which may be high or low because of one-time factors that don’t reflect the prospects of the firm. On the other hand, a company’s forward P/E can be artificially deflated by a rosy earnings estimate, particularly in a boom period. Additionally, earnings are volatile in the short-term, and profit margins tend to revert to a long-term average over a business cycle-further clouding the usefulness of the forward P/E. Still, the forward P/E is often used to analyze the valuation of a company relative to how much they actually expect to earn.