There are numerous ratios with unique characteristics to evaluate the performance of a company, i.e. leverage ratios, liquidity ratios, etc. One such ratio is the P/E ratio or Price to Earnings Ratio. It helps in calculating the growth of the company’s stock. However, there is one more elevated version of this ratio known as the forward P/E ratio. It helps in finding the future prospect of a company’s share price.
This article will cover this interesting ratio’s meaning and importance and calculate it in Excel.
What is the forward PE ratio? How is it different from normal PE?
Forward price-to-earnings (forward P/E) is a version of the ratio of price-to-earnings (P/E) that uses forecasted earnings for the share price calculation. Investors and analysts around the world use this ratio to gauge the value of a company by taking estimates of its future earnings.
Unlike the P/E ratio, which considers the available past data on earnings and the price of shares, forward P/E is based on the estimation of earnings of a company and provides insights on how the stock is likely to be a few years down the line. From the valuation standpoint, the forward P/E ratio is considered more relevant than the normal P/E.
For calculating forward P/E, we need to add future estimation of earnings in the denominator instead of current earnings. While the earnings used in the forward PE ratio are estimated numbers and may not be as reliable as current data, this ratio still benefits companies by getting a forecast of their future earnings and share price.
Why is it crucial for businesses and investors to calculate the forward PE ratio?
Forward PE is widely used for comparison across companies. Investors use this ratio along with others to check how a company stands relative to its competitors in the same industry. It is a part of the validation model cold relative valuation, wherein ratios are used to gauge the relative values of a company.
Forward P/E ratios not only help Investors to understand their growth prospects and where a company stands in the competition, but it also acts as a straightforward metric of valuation. On the other hand, for companies, it shows the future road and helps them stay on track with their goals. As Earnings reflect all the fundamentals of a business, companies evaluate future earnings for forward P/E as how successful they estimate themselves to be in the future.
What is the formula for forward P/E ratio?
The formula for forward P/E is almost analogous to the PE ratio. However, estimated (or forecasted) earnings per share are used instead of current or historical share price in forward PE. Projected earnings could be for the following year or years, depending on the requirement.
Forward P/E = Current Share Price / Estimated Future Earnings Per Share
For example, if a company has a current share price of Rs. 100, and next year’s earnings per share (EPS) is expected to be Rs. 5, then the company has a forward P/E ratio of 20.0x.
Here, the only challenge is to find out what the estimated future earnings of the company would be. Investors can use their own estimates. However, there are various databases like Bloomberg, Capital IQ, Yahoo Finance, Equity Research reports, etc., where an investor can find the estimated EPS based on business fundamentals.
How to Calculate the Forward PE ratio in Excel?
Let’s talk about the calculation part in Excel now. Once the future earnings are in handy, finding forward P/E becomes very easy. Here is an example of how this works in Excel.
Select a company or companies to calculate forward P/E and get the relevant data such as market price and earnings. All that is needed is to divide the market price by earnings to get forward P/E/. See the steps below.
-> Open an Excel sheet and enter the titles shown in the snapshot below. We will start by calculating forward P/E for ABC Ltd.
-> We can calculate the forward P/E with the help of the formula= Current Share Price / Estimated Future Earnings Per Share.
-> For that, place the cursor in cell B4 and press‘=’ sign (as all formulas in excel begin with that sign) and type the formula as B2/B3. After pressing enter we can get the forward PE for company ABC.
-> Similarly, forward P/E for company XYZ Ltd. can be calculated. The result will look like this:
-> In the above illustration, ABC Ltd has a slightly higher forward P/E ratio compared to XYZ Ltd based on the price and forecast.
For the forward P/E ratio, results under 10- 25 are considered reasonably priced stocks. Stocks under 10 can be undervalued if their fundamentals are strong. If the ratio is above 50, the stock is overvalued and should be avoided. Both the stocks of ABC and XYZ are below 10. Investors should check other fundamental values before investing in them,
Conclusion
There are many ways and attributes to value the company. P/E and forward P/E are one of the most sought-after ratios in finance, but they should not be looked at in isolation. Forward P/E ratio accounts for estimated earnings, and thus this calculation holds utmost importance to ensure that the findings are reliable. Faulty estimations can distort the value of a company and thus needs careful consideration.
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