Comparing Trailing vs. Forward P/E Ratios: Which Predicts Stock Returns Better?

P/E

In the realm of value investing, savvy investors often seek out undervalued gems by categorizing stocks into quartiles based on their Price-to-Earnings (P/E) ratios. Their strategy typically involves honing in on stocks with the lowest P/E ratios, operating under the belief that these stocks tend to outshine their counterparts with higher trailing P/E ratios. Conversely, there’s another camp of investors who prefer utilizing forward P/E ratios to pinpoint stocks they anticipate will outperform.

Unveiling the Predictive Power

The burning question arises: which metric holds superior predictive power in terms of stock returns – trailing or forward P/E ratios? And do stocks within the low P/E quartile yield higher or lower returns compared to those in the high P/E quartile, contingent upon whether P/E is calculated based on trailing or forward earnings?

Undoubtedly, low P/E stocks triumph over high P/E stocks, backed by overwhelming evidence. These low P/E stocks consistently outperform their high P/E counterparts by a notable margin, ranging between 6 to 13 percent, varying by geographical location. This outperformance remains consistent across different time frames, economic cycles, and market conditions. However, the debate lingers on regarding which stocks fare better – those with low forward P/E or low trailing P/E.

The Dichotomy of Forward P/E Ratios

Presently, forward P/E ratios appear relatively reasonable when juxtaposed with historical averages, especially within emerging markets and growth indexes, as opposed to trailing P/Es, which often deviate. Does this imply a rush towards acquiring Nasdaq-listed or emerging market ETFs?

Not so fast. My research indicates that while forward P/E ratios serve as a reliable indicator of future returns for certain markets like the NYSE, their predictive prowess falters in other markets – such as Nasdaq – housing the riskier spectrum of stocks, including emerging market ETFs.

Market Insights Unveiled

Delving deeper, my findings reveal that stocks within the lowest quartile of forward P/E exhibit comparable returns to high forward P/E quartile stocks in the AMEX-listed domain (now recognized as NYSE American). However, they outshine high P/E quartile stocks by 2.4 percent for Nasdaq and a staggering 11.64 percent for NYSE stocks.

Conversely, when examining trailing P/E ratios, low trailing P/E quartile stocks surpass high P/E quartile stocks by 6.24 percent for AMEX, 11.4 percent for Nasdaq, and 9 percent for NYSE stocks.

Unveiling the Forensic Analysis

The disparity in forecasting ability between forward and trailing P/E ratios stems from a fundamental divergence in their underlying mechanisms. Trailing earnings are grounded in realized earnings, whereas forward earnings hinge on projections furnished by analysts. Analysts, by nature, tend to lean towards optimism when forecasting earnings, thereby inflating forward P/E ratios, creating a facade of a low P/E scenario that may not be reflective of reality. Subsequently, earnings revisions downward unveil the true nature of the stock’s valuation, transitioning what seemed like a value stock into a high P/E entity.

The Analyst Bias Unveiled

On average, analysts tend to overestimate actual earnings by approximately 2.5 percent within a calendar year, with the overestimation peaking at around 8 percent at the onset of the forecasting period. Nevertheless, accuracy tends to improve as analysts approach the year’s end they are forecasting.

Notably, analysts’ propensity for over-optimism varies across companies. It predominantly surfaces around stocks entwined with high degrees of uncertainty. Conversely, for stocks with low uncertainty, analysts’ forecasts tend to align closely with actual outcomes. Specifically, for stocks with the lowest uncertainty, analysts exhibit virtually no upward bias in earnings forecasts within a calendar year.

Uncertainty Unraveled

However, when examining stocks enveloped in high uncertainty, analysts veer towards overestimating actual earnings by a staggering 21 percent on average. These substantial errors underscore the inadequacy of forward P/E ratios, particularly within this subset of high-uncertainty stocks.

Conclusion: Embracing the Value Investor’s Approach

In essence, while forward P/E ratios may hold predictive merit for stocks with low uncertainty, their accuracy wanes for stocks plagued by high uncertainty. This discrepancy elucidates why forward P/E ratios excel in forecasting future returns for NYSE stocks but falter in comparison (to trailing P/E ratios) for AMEX and Nasdaq stocks – notably, the riskier stock categories.

Hence, for investors aiming to mitigate uncertainty surrounding a company’s future trajectory, adopting trailing P/E ratios as a steadfast screening tool is prudent. This mirrors the approach championed by the father of value investing, Benjamin Graham, in his quest to identify potential outperformers. As such, investors are advised to heed his wisdom, especially in navigating risk-laden markets.

Reference:

Trailing or forward P/Es: Here’s which one has the better predictive power for picking winning stocks

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