What it means
Share prices are forward-looking, so investors care more about what a company will earn than what it has earned. Forward earnings put a number on that expectation, normally expressed per share so that it can be compared directly with the share price.
Where several analysts publish forecasts, the average of them is called the consensus. The most common use is the forward price-to-earnings ratio, which divides the current share price by expected earnings per share.
It lets investors compare a company that is growing quickly with one that is not, because a business whose profits are about to double will look expensive on past earnings and reasonable on future ones. For company management, forward earnings are a communication tool as much as a measure.
Guidance issued to the market sets the expectation against which the next results will be judged, which is why a company can report record profits and still see its share price fall if those profits came in below the forward number. The obvious weakness is that forecasts are wrong in predictable ways.
Analyst estimates tend to start out optimistic and drift down as the year progresses, and forecasts for cyclical businesses are least reliable exactly when the cycle is turning. Tracking the direction of revisions is often more informative than the level of the estimate itself.
There is also a definitional trap. Many forward earnings figures are adjusted, excluding restructuring costs, share-based payment or amortisation of acquired intangibles, so a forward figure and a reported figure may not be measuring the same thing at all.
In practice
Real-world examples.
Example
An analyst compares two software companies on the same trailing ratio of 30 times. One is expected to grow earnings 25% next year and the other 5%, so their forward ratios are far apart and the comparison finally becomes useful.
Example
A retailer issues a profit warning in October, cutting guidance for the year. Consensus forward earnings fall by 12% within a week, and the share price falls with them even though no results have yet been published.
Example
A private company preparing for sale builds a forecast of next year's profits to support its asking price. The buyer accepts the concept of forward earnings but discounts the forecast heavily, since the seller controls the assumptions behind it.
Formula
Calculation
Forward earnings per share = Forecast net income / Diluted shares outstanding. Forward price-to-earnings ratio = Current share price / Forward earnings per share.
A listed industrial group is expected to earn net income of $84,000,000 next year and has 40,000,000 diluted shares in issue.
Forward earnings per share = 84,000,000 / 40,000,000 = $2.10.
With the shares trading at $37.80, the forward price-to-earnings ratio is 37.80 / 2.10 = 18.0 times.
The company reported earnings per share of $1.80 for the year just ended, so its trailing price-to-earnings ratio is 37.80 / 1.80 = 21.0 times. The gap between 21.0 and 18.0 reflects expected earnings growth of (2.10 - 1.80) / 1.80 = 16.7%, and the whole case for buying at 18 times rests on that growth actually arriving.Case study
Seen in the real world.
Halloway Precision Tools is a fictional manufacturer created to illustrate the point. Ahead of an equity raise, its management published guidance implying forward earnings per share of $2.40 against $1.90 reported for the prior year, and the shares were priced on a forward ratio that looked modest in comparison with its peers.
Two things went wrong in this illustrative story. The guidance depended on a new plant reaching full output by the middle of the year, and it defined earnings on an adjusted basis that excluded around $6,000,000 of restructuring costs the company knew it would incur.
When the plant ramp slipped by a quarter, forward earnings per share were cut to $2.05, and investors discovered that the reported figure would be materially lower again once the excluded costs were counted. The shares fell more than the earnings revision alone would suggest, because the market repriced the credibility of the guidance as well. The fictional lesson is that forward earnings are only as good as the assumptions and the definition behind them.
Watch out
Common mistakes.
- Treating consensus forward earnings as a fact rather than an average of opinions that will be revised repeatedly before the period ends.
- Comparing a forward price-to-earnings ratio for one company with a trailing ratio for another, which makes the growing business look artificially cheap or expensive.
- Ignoring whether the forward number is adjusted, so a figure that excludes real recurring costs is compared with a reported figure that includes them.
Questions
People also ask.
Where do forward earnings come from?
Usually from a consensus of analyst forecasts, from the company's own published guidance, or from an investor's own model built on revenue and margin assumptions.
Why is a forward price-to-earnings ratio usually lower than the trailing one?
Because most companies are expected to grow, so the larger expected earnings figure in the denominator produces a smaller ratio.
How should I use forward earnings sensibly?
Look at the direction and size of recent revisions, check the assumptions behind the forecast, and test what the valuation looks like if the growth simply does not happen.
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