P/E ratios: Forward or Backward?
The stock market is a market of stocks. Think about how everyone chooses a stock investment.
You can look at the history of earnings — and you should. Past earnings show how the company has performed, the numbers are set, and our information is as good as possible.
Good analysts do not stop there, since what they have is perfect rear-view mirror information. Think about how you would evaluate Google, or GM, or Amgen, or RIG, or Intel. Good analysts start asking all sorts of forward-looking questions like the following:
- Will the new product launch be successful?
- Will the current pace of earnings growth continue?
- What does the drug pipeline portend?
- Is there a lot of inventory in the channel?
- Will the FDA trial succeed?
- How might expected economic trends affect earnings potential?
And so forth. Analysts look forward in estimating earnings. Investors in individual stocks look at past performance, but base purchase decisions on future earnings expectations. This is consistent with the strongest stock selection methodology, treating the stock price as the discounted future cash or earnings flow.
This raises an important question: Why do those looking at the overall market choose to look backward?
The parade of talking heads on CNBC and those in the punditry all talk about the market P/E in terms of the past. This helps to explain why using the trailing P/E ratio is such a poor model.
It fails as a descriptive model, because it does not represent what investors really do on individual stock decisions.
It fails as a prescriptive model, because when you complete the analysis of the past, you then have to make a seat-of-the-pants adjustment for what market multiple is appropriate.
Perfect backward information is no match for a careful forward look. We’ll pursue this theme further.