Forward vs. trailing price to earnings: Here’s the better metric to use for predicting stock returns

Price-to-earnings, or P/E, is the go-to valuation metric in virtually any stock analysis, but here’s where it gets interesting: There are two versions, and their signals to investors can differ materially.

However, the forward P/E gives a different signal – that the S&P 500 is undervalued when compared with the historical experience. For example, the 2019 forward P/E is 17, while the 2020 forward P/E is 15.3, versus a long-term average of 17.8.There are definitely preferences on which metric to use.

Now that we know which metric is superior, now the question is why? Why do low forward P/E ratio stocks produce, in general, inferior stock performance when compared with low trailing P/E ratio stocks? This question can be generalized to: Why do trailing P/E ratios provide a better investing tool than forward P/E ratios?

For example, on average within a calendar year, analysts overestimate actual earnings by about 2.5 per cent. But the overestimation is about 8 per cent at the start of the forecasting period. Accuracy improves as analysts approach the end of the year that they are forecasting.

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