The price-to-earnings ratio is one of the first valuation tools most investors learn. But there are two versions, and they can tell very different stories. The forward P/E ratio values a company on the profits it is expected to make, not the profits it has already made. That makes it widely used, and also easy to misread.
What the forward P/E is
The forward P/E ratio divides a company’s current share price by its expected earnings per share, usually for the next 12 months or the next financial year. If a share costs £20 and analysts expect earnings of £1 per share next year, the forward P/E is 20. In plain terms, investors are paying 20 times next year’s expected profit.
The trailing P/E, by contrast, uses earnings from the past 12 months. Our guide to the price-to-earnings ratio explains the basics of both.
Why investors use it
Share prices are driven by expectations about the future, so a valuation based on future earnings often makes more sense than one based on the past. The forward P/E is especially useful for fast-growing companies, whose past earnings may be much smaller than what they are expected to earn soon. It is also used to compare a company with its own history, with its competitors and with the wider market.
Market strategists often quote the forward P/E of whole indices, such as the S&P 500 or FTSE 100, as a quick gauge of how expensive markets look compared with history.
Where the forecasts come from
The earnings figure in a forward P/E is usually an average of analysts’ forecasts, known as the consensus estimate. Data providers collect forecasts from many analysts and calculate the average. Some companies also give their own guidance, which analysts use as a starting point.
The big weakness
The forward P/E is only as good as the forecasts behind it, and forecasts can be wrong. Analysts often start the year too optimistic and cut estimates as the year goes on. If earnings disappoint, a share that looked cheap on a forward P/E may turn out to be expensive. When the economy turns down, forecasts can fall sharply and quickly.
That is why the forward P/E can change even when the share price does not. If analysts raise their earnings forecasts, the forward P/E falls. If they cut them, it rises. Watching the direction of estimate revisions can be as important as the ratio itself.
How to use it sensibly
Compare forward and trailing P/E ratios side by side. A forward P/E far below the trailing figure means strong growth is expected, and you should ask whether that growth is realistic. Compare companies within the same industry, because different sectors naturally trade on different multiples. Consider interest rates too: higher rates usually justify lower multiples, because safe alternatives offer better returns.
Common mistakes
The first mistake is treating a low forward P/E as proof a share is cheap. It may be low because the market doubts the forecasts. The second is ignoring debt, which the P/E does not capture. The third is relying on a single valuation measure. Free cash flow, margins and the balance sheet all add context.
The beginner takeaway
The forward P/E tells you what investors are paying for expected profits. It is a useful starting point, provided you remember it is built on forecasts, not facts. If you want to see how carefully you test assumptions before you trade, take the free Samuel & Co Trading Trader Assessment.
