Valuing a Stock on Earnings That Have Not Happened Yet
A price earnings ratio can use past earnings or forecast earnings. The choice matters, because trailing earnings are certain but backward looking, while forward earnings are relevant but uncertain.
Two Versions of the Same Ratio
The price to earnings ratio compares a stock price to its earnings, but there is an ambiguity hiding in it: which earnings? The ratio can use trailing earnings, the actual earnings the company reported over the past period, or forward earnings, the earnings the company is forecast to make over the coming period.
These produce different numbers and carry different meanings, and confusing them, or not knowing which is being quoted, leads to mistakes. The choice between them reflects a genuine tension between using data that is certain but backward looking and data that is relevant but uncertain.
Trailing earnings are what the company actually made and cannot change. Forward earnings are what it might make and could be wrong. The first is real, the second is relevant, and they are rarely equal.
The Trade Between Them
| Trailing | Forward | |
|---|---|---|
| Based on | Actual past earnings | Forecast future earnings |
| Certainty | Real, already happened | A forecast, may be wrong |
| Relevance | Backward looking | Forward looking |
| Best for | Stable companies | Companies whose future differs from past |
Trailing earnings have the virtue of being real: they actually happened and are not a matter of opinion. Their weakness is that they are backward looking, and a stock is valued on its future, not its past. Forward earnings have the opposite profile: they are what matters for value, since they reflect the future, but they are a forecast and therefore uncertain, and forecasts are often wrong, frequently too optimistic.
When the Difference Matters Most
The gap between trailing and forward earnings matters most when the future is expected to differ sharply from the past. For a company whose earnings are growing fast, forward earnings are much higher than trailing, so the forward multiple is much lower, and using the trailing multiple makes the stock look more expensive than it is relative to where earnings are heading.
The reverse happens for a company whose earnings are about to fall. Trailing earnings are high and the trailing multiple looks reasonable, but forward earnings are lower, so the forward multiple is higher, revealing the stock is more expensive than the trailing figure suggests. For a cyclical company at a peak, this is exactly the trap discussed in normalizing earnings: the trailing multiple looks cheap while forward earnings, and the true value, are about to decline.
The Forecast Problem
Forward earnings depend on forecasts, and forecasts have a known bias: they tend to be too optimistic, especially further out. Analysts systematically overestimate future earnings on average, so forward multiples based on their forecasts tend to look lower, cheaper, than the earnings will actually justify.
This means a forward multiple should be treated with some skepticism, since it rests on estimates that often prove too high. A stock that looks cheap on forward earnings may be less cheap once the optimistic forecasts are revised down, which they frequently are. The forward multiple is more relevant but rests on a foundation that tends to flatter, and knowing whose forecast is behind it, and how reliable such forecasts have been, matters for trusting it.
Using Them Together
The practical approach uses both. The trailing multiple provides a grounded, factual anchor based on what actually happened, and the forward multiple provides the forward looking relevance, tempered by awareness that the forecast may be optimistic.
Comparing them is itself informative: a forward multiple much lower than the trailing one signals expected earnings growth, while a forward multiple higher than trailing signals expected decline. The gap between them reveals what the market and analysts expect to happen to earnings, which is useful beyond either figure alone. Knowing which multiple is being quoted, and looking at both, avoids the mistakes that come from confusing the certain past with the relevant but uncertain future.
The Bottom Line
The price to earnings ratio can use trailing earnings, which are real but backward looking, or forward earnings, which are relevant but a forecast that may be wrong. The difference matters most when the future is expected to differ sharply from the past, as for fast growing or cyclical companies, where the trailing multiple can badly mislead. Forward earnings tend to rest on optimistic forecasts, so the forward multiple often flatters, and the sound approach uses both, treating the gap between them as a signal of expected earnings growth or decline.