Forecasting Earnings Based On the P/E Ratio
Past, future or average earnings can be used
The price to earnings (P/E) ratio is a common formula used in the analysis of stocks and stock markets. It tells you the amount investors are willing to pay for a dollar of reported profits. There are several different ways the P/E ratio can be calculated. Below are the three most commonly used calculations.
Last Year’s Earnings
This calculation takes the current price of a stock divided by last year’s corporate earnings.
Let's look at a company whose stock price is $50/share. Let's assume the company is making a profit and reported earnings of $5/share. The P/E would be $50/$5 or a 10 to 1 ratio. It means that, at the current price, investors are willing to pay $10 for every $1 of reported earnings.
The problem with relying on this calculation is the possibility that next year will be nothing like last year; corporate earnings could help me much higher, or much lower.
This calculation takes the current price of the stock (or group of stocks) divided by an average of all of the predicted earnings put forth by analysts and the companies themselves. The problem with this calculation is there are numerous occasions where companies do not earn what they were projected to earn.
That guessing game is what makes stocks and the stock market so difficult to evaluate. No one truly knows what will happen next year. Professional investors or investment management companies will make forecasts. Some will be right, and some will be wrong.
Analyst opinions and forecasts will always be changing as new information becomes available.
When you look at stock research websites, they will normally provide you with ratios based on past and projected earnings. It gives you a frame of reference to use when comparing one company to another company that is in the same industry. If two similar companies have vastly different P/E ratios, you'll want to do more research to find out why.
Ten Year Average
This calculation is most often used to look at the value of an entire market instead of an individual stock. It takes the current price of the market divided by corporate earnings as averaged over the past ten years. This ratio is called P/E 10, and the method was developed by Professor Robert Schilling. It is designed to even out the inconsistencies that can come from using only one year of past or projected earnings' data.
Much research supports the validity of P/E 10 as an appropriate way to value a market as a whole. It can be useful in figuring out where things are relative to the past. This data is often used to determine how "expensive" the market is.
When running statistics on the stock market, it is often best to use all three types of P/E ratios - not just one. Regardless of which way you look at P/E ratios, the information is useless unless you can put it in perspective.