How to Forecast Earnings Based on the P/E Ratio

The price to earnings (P/E) ratio is a common formula used in the analysis of stocks and stock markets. It tells you the amount investors are willing to pay for a dollar of reported profits. There are several different ways the P/E ratio can be calculated.

Learn more about the three ways to calculate this ratio and what you can learn from each.

What Are the Three Types of Calculations?

Below are the three most commonly used calculations.

1. Last Year’s Earnings

This takes the current price of a stock divided by last year’s corporate earnings.

Let's look at a company with a stock price of $50/share. Let's assume the company is making a profit; it reported earnings of $5/share. The P/E would be $50/$5, or a 10:1 ratio. It means that, at the current price, investors are willing to pay $10 for every $1 of reported earnings.

The problem with relying on this calculation is the possibility that next year will be nothing like last year. Corporate earnings could be much higher or much lower.

2. Earnings Forecast

This calculation takes the current price of the stock or group of stocks. Then, it's divided by an average of all of the predicted earnings put forth by analysts and the companies themselves.

What's the problem with this calculation? There are plenty of times when companies do not earn what they were projected to earn. 

That guessing game is what makes stocks and the stock market so difficult to predict. No one truly knows what will happen next year. Professional investors or investment management companies will make forecasts. Some will be right, and some will be wrong.

When you look at stock research websites, they will normally provide you with ratios based on past and projected earnings. It gives you a frame of reference to use when comparing one company to another in the same industry. It's possible that similar companies will have vastly different P/E ratios. In that case, you'll want to do more research to find out why. 

3. Ten-Year Average

This calculation is most often used to look at the value of an entire market instead of an individual stock. It takes the current price of the market; then, it's divided by corporate earnings as averaged over the past 10 years. This ratio is called P/E 10. It is designed to even out the inconsistencies that can come from using only one year of past or projected earnings data. 

Research supports the P/E 10 as an appropriate way to value a market as a whole. It can be useful in finding out where things are relative to the past. This data is often used to determine how "expensive" the market is.

The Bottom Line

When running statistics on the stock market, it is often best to use all three types of P/E ratios. Using just one can show an incomplete picture.

Regardless of which way you look at P/E ratios, the information is useless unless you can put it in perspective.