What is the Forward P/E Ratio?
The Forward P/E Ratio is a variation of the price-to-earnings ratio in which a company’s forecasted earnings per share (EPS) is used rather than its historical EPS.
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How to Calculate the Forward P/E Ratio
The question answered by the forward P/E ratio is:
- “How much are investors willing to pay today for a dollar of a company’s future earnings?”
A forward variation is sometimes used because a company’s future earnings could reflect its real financial performance more accurately, i.e. the company’s future profitability is likely to change substantially in the near term.
Most often, the companies valued using the forward multiples are high-growth companies that have either yet to break even or are barely profitable today.
The implicit assumption is that in the coming year, the company will figure out methods to monetize its customer base better and become more profitable.
Forward Multiples and Company Lifecycle
High-growth companies typically prioritize acquiring new customers and achieving out-sized growth at all costs, even if it means enduring an unsustainable cash burn rate.
The historical earnings are thereby assumed to be more-so “experimental” with regards to identifying their target customer profile and improving their go-to-market strategies for customer acquisition.
These companies can often afford to do so due to having a “cushion” to fall back on, i.e. existing investors (or new investors) to provide them with more capital if needed.
Forward P/E Ratio Formula
The formula for calculating the forward P/E ratio divides a company’s share price by its estimated earnings per share (EPS).
Forward P/E Ratio Formula
- Forward P/E = Current Share Price / Forecasted EPS
Forward P/E vs. Trailing P/E Ratio
By contrast, the trailing price-to-earnings ratio (P/E) – the more prevalent P/E ratio – relies on a company’s historical EPS reported in a past period.
Trailing P/E Ratio Formula
- Trailing P/E = Current Share Price / Historical EPS
The advantage of using the trailing P/E ratio is that the earnings metric is not based on discretionary forward-looking assumptions, as the EPS figure can be confirmed as factual based on historical performance.
Pros/Cons of Forward Multiples
Certain unprofitable companies have no other option but to use forward P/E ratios, as a negative EPS would make the ratio meaningless.
However, forward valuation multiples are not used exclusively for unprofitable companies, as often both the trailing and forward P/E ratios are often presented side by side.
One distinct benefit to forward P/E ratios is that the underlying company’s financials are “normalized,” e.g. the effects of non-recurring items are removed.
The limitation to the forward P/E ratio is its reliance on forecasting estimated earnings, causing it to be subject to bias (and perhaps leading to an implied value that deviates from reality).
Since forward P/E ratios are based on the subjective opinions of different equity analysts, the ratios can vary substantially from person to person, as each individual has their own unique perspective on a company’s growth potential.
Forward P/E Ratio Calculator – Excel Template
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Forward P/E Example Calculation
Suppose a company’s market share price is currently $30.00 as of the latest closing date.
- Current Share Price = $30.00
- EPS 2021A = ($0.10)
Based on estimates from equity analysts, the company’s EPS is expected to reach $0.50 in 2022 and then $1.50 in 2023.
- EPS 2022E = $0.50
- EPS 2023E = $1.50
Using the current share price, the trailing, one-year forward, and two-year forward P/E ratio can be calculated.
- Trailing P/E = $30.00 / ($0.10) = NM
- One-Year Forward P/E = $30.00 / $0.50 = 60.0x
- Two-Year Forward P/E = $30.00 / $1.50 = 20.0x
The trailing P/E is not meaningful (i.e. “NM”) because of the negative EPS figure.
The EPS in the one-year forward P/E is no longer negative, but since the company is still barely profitable, the calculated 60.0x P/E ratio is still not too useful.
The two-year forward P/E comes out to 20.0x, which is more practical for performing valuation analysis and for comparisons against industry peers.
The longer the forecast, the more a company’s earnings tend to normalize over time and converge towards the industry average, which is why multiples decline as a company matures.
However, the fact that the two-year forward EPS is from a projection model that was based on discretionary assumptions causes it to be less credible.