The Forward Price/Earnings Ratio, or Forward PE Ratio is the second-most important measure of the value of a company or of a market sector. You may never know this from watching business shows on TV as they focus on hundreds of esoteric details in trying to predict the direction of a stock.
It drives me crazy when the business announcer on the radio says, “The markets are up today due to good pork belly futures price reports coming out of Thailand.” This is gibberish, in my opinion. Most of what the broadcast media says about short-term movements of the markets is a bunch of hooey.
Remember, when we invest in stock, we usually aren’t giving any of our investment directly to the company, since stocks trade on the secondary markets. Investors purchase stocks because they believe the company will earn a lot of profit in the future, relative to what they are paying for that stock. The goal is to buy stocks when we think they are undervalued. This is why I adore XYZ Company at $25, like it at $40 and want nothing to do with it at $200.
The “forward” of the PE Ratio is the expectation of next year’s profit per share based on the average estimate from all analysts covering that company. For example, if ABC trades at $90 per share, and projected earnings per share next year are $6, then 90/6 yields a Forward PE ratio of 15. The long term historical average PE ratio of the U.S. stock market is about 16 times earnings. The lower the PE Ratio, the better.
You are paying 15 times net profit to own ABC company at $90 with expected earnings of $6 over the coming year. How accurate are these estimates you ask? To answer that question, think about all the times you hear about a company beating analyst estimates, or falling short by 1 or 2 cents per share.
So how can this help? In my other book, The Black Book on Personal Finance, I performed a case study on the stock market crash in the early 2000’s. What I concluded was that we did not have a market crash. Instead, we had a crash of the part of the market that had an average PE of 200 times earnings (NASDAQ).
The rest of the market did just fine during this time, and the sectors with single digit PEs had huge rallies! So investors who applied this one principal could have made money during the dot-com market crash. Investing based on PE is a way to apply the concept of “buying low.” Warren Buffett has made a pretty decent living applying this concept.