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Price-to-earnings, or P/E, is the go-to valuation metric in virtually any stock analysis, but here’s where it gets interesting: There are two versions, and their signals to investors can differ materially.

One doesn’t have to look far to see this: The S&P 500 trailing P/E (looking back 12 months at actual earnings) is currently 18.7 versus a long-term average (since 1969) of 16.7, according to Bloomberg. This signals a possibly overvalued market, in other words, that the chances of a decline are high.

However, the forward P/E (looking at projected earnings) gives a different signal – that the S&P 500 is undervalued when compared with the historical experience. For example, the 2019 forward P/E is 17, while the 2020 forward P/E is 15.3, versus a long-term average (since 1990) of 17.8.

There are definitely preferences on which metric to use. Value investors, also known as bottom-up investors, like to sort stocks by trailing P/E ratios into quartiles (or deciles) and focus only on the lowest P/E quartile (or decile) because they believe that stocks that have low valuations in relation to trailing earnings, on average, outperform. On the other hand, top-down professionals like to report and use forward P/E ratios to identify outperforming stocks. But which metric has a better predictive power as far as stock returns are concerned – trailing or forward P/E ratios?

I tried to answer this question in a recent study I carried out in which I asked the following question: Which P/E metric, forward or trailing, gives better results when we compare the performance of low P/E quartile stocks against that of high P/E quartile stocks? What I found was that while forward P/E ratios are a good predictor of future returns for stocks listed on the New York Stock Exchange (NYSE), they are not as good a predictor for shares on the American Stock Exchange (now known as NYSE American) and Nasdaq. On the other hand, trailing P/E ratios are a good predictor of future returns in all exchanges referred to above. It also became clear in my study that had an investor focused on low trailing P/E ratio stocks she would have done much better than focusing on low forward P/E ratio stocks.

Now that we know which metric is superior, now the question is why? Why do low forward P/E ratio stocks produce, in general, inferior stock performance when compared with low trailing P/E ratio stocks? This question can be generalized to: Why do trailing P/E ratios provide a better investing tool than forward P/E ratios?

The answer is simple. Trailing earnings are based on realized earnings, while forward earnings are based on earnings forecast by analysts. Analysts tend to be overoptimistic when forecasting earnings. This biases forward P/E ratios down, giving the impression that a stock commands a low P/E, when in fact this may not be the case because earnings are eventually revised downward and what appeared at first to be a value stock may, in fact, turn out to be a high P/E stock.

For example, on average within a calendar year, analysts overestimate actual earnings by about 2.5 per cent. But the overestimation is about 8 per cent at the start of the forecasting period. Accuracy improves as analysts approach the end of the year that they are forecasting.

What is more interesting, however, is that analysts are not overoptimistic across all companies covered. They tend to be overoptimistic only for stocks for which there is high uncertainty about the future. For stocks with low uncertainty, analysts tend to be pretty accurate. In fact, I find that for the lowest uncertainty stocks, analysts, on average, exhibit no upward earnings forecast bias within a calendar year. But when it comes to the highest uncertainty group of stocks, on average, analysts tend to overestimate actual earnings by 21 per cent. These are big errors, hence the inaccuracy of forward P/E ratios, particularly for this group of stocks.

In other words, forward P/E ratios can be a good predictor of future returns for low uncertainty stocks but are quite inaccurate for high uncertainty stocks. This may explain why forward P/E ratios work well in predicting future returns for NYSE stocks, but they do not work as well (compared with trailing P/E ratios) for NYSE American and Nasdaq stocks – what are historically the riskier group of stocks. As a result, if investors want to stop worrying about the uncertainty underlying a company’s future, they should consistently use trailing P/E ratios to screen stocks.

In fact, this is the approach that Benjamin Graham, the father of value investing, followed when he wanted to identify stocks that were likely to outperform. Investors should follow his lead, especially when it comes to riskier markets.

George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario.