PE Ratio – Based on Trailing or Projected EPS?

Peter McMurtry, B.Com, CFA, Financial Writer

Strategies For Do-It-Yourself Investors™

Many financial databases and retail investors use trailing twelve month (TTM) earnings when evaluating a company’s PE ratio. Are they correct?

My thirty years of experience as a portfolio manager and investment analyst makes me question this logic. I have always preferred using projected earnings as a more useful indicator.

The stock market anticipates the future, rightly or wrongly. It is an estimate, but still the best and most informed outlook available at the time. I use projected earnings based on the consensus of all the analysts covering the stock.

The problem with using past earnings only is that it is a very poor indicator for companies experiencing a major change in direction either positive or negative.

For a company about to register a strong earnings uptick, using past earnings for the PE calculation really will miss this turnaround until much later.

For a company that has performed very well recently, but is about to face some stiff competition or changes in government regulations going forward, using trailing twelve month earnings will be a poor indicator of the future earnings of the company.

The advantage of a PE ratio based on projected earnings is that both the share price and earnings will move accordingly, which is exactly as it should be.

This is comparable to passive ( strategic) asset allocation strategies versus active or tactical ones. Passive strategies do not attempt to predict the future and only react after markets move. Active asset mix strategies attempt to predict the future by estimating one year future returns for every asset class.

Historical fixed income returns over the last many years have been excellent. However if an investor simply used past performance as an indicator of future returns, they would be sorely disappointed with fixed income returns in the current environment of rising interest rates.

My recommendation is to use projected earnings when calculating the PE ratio of a company.

Posted in Blog Post.

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