Dumb Alpha: Trailing or Forward Earnings?

Value investing is a form of creating dumb alpha. After all, in its simplest iteration, value investing boils down to selecting stocks with the lowest price-to-earnings (P/E) ratio or lowest price-to-book (P/B) ratio. What could be simpler than that?

But alas, the financial industry, in its eternal drive to make things more complicated than they need to be, has managed to confuse investors about this concept as well.

All too often, investment reports or the financial media maintain that a stock is attractively valued because its forward P/E ratio is such and such. These kinds of statements have become a pet peeve of mine. Why? Because very few people ever stop to check if forward P/E ratios are actually predictive of future outperformance.

All the studies on the value factor have been conducted with trailing P/B and trailing P/E ratios, not forward P/E ratios. Recognizing this difference is critical to becoming a successful value investor.

To demonstrate how reliable P/E ratios are as a source of dumb alpha, I took the current index constituents of four major stock market indices: the S&P 500 in the United States, the FTSE 350 in the United Kingdom, the Euro StoXX 300 in the eurozone, and the Nikkei 225 in Japan. For each, I chose the 20% of stocks with the lowest P/E ratios and compared their average returns to the 20% of stocks with the highest P/E ratios going back monthly for the past 20 years. I first used trailing 12-month P/E ratios for each stock and then switched to forward 12-month P/E ratios. For the latter, I followed common practice and used the P/E ratio calculated with Institutional Brokers' Estimates System (I/B/E/S) consensus earnings forecasts.

The results of the exercise are instructive: In the United States, the cheapest quintile of stocks based on trailing P/E outperformed the most expensive by 1.2% per year. When using forward P/E ratios, on the other hand, the most affordable stocks underperformed the priciest by 1% annually. In other words, relying on forward P/E ratios destroyed performance!

In the United Kingdom, the picture is not quite as bad. Sorting stocks based on trailing P/E led to a 10.1% annual outperformance by the cheap stocks, while sorting based on forward P/E created a 7.4% outperformance. But here again, employing forward P/E was significantly less successful than trailing P/E.

In the eurozone, based on trailing P/E, inexpensive stocks did 4.6% better per year compared to 3.5% for forward P/E. And finally, even in Japan using trailing P/E led to a 6.6% annual outperformance by the cheapest quintile of stocks compared to just a 0.6% outperformance with forward P/E.

These exercises demonstrate that, regardless of region, relying on forward P/E ratios as a value indicator is less effective than trailing P/E ratios and can sometimes completely destroy the value premium investors seek to harvest. The same picture emerges when risk-adjusted returns are the measure of success or if country or sector indices are employed instead of single stocks.

Why don't forward P/E ratios work as a measure of value? The answer is rooted in analysts’ estimates of future company earnings. As I demonstrated in the second installment of this series, analysts are terrible at predicting interest rates, exchange rates, or stock market performance over the coming 12 months. And they are similarly inept at predicting company earnings. In fact, using trailing 12-month earnings is typically a better predictor than analyst-estimated forward earnings. This is why trailing P/E ratios do a better job at selecting value stocks than forward P/Es.

What explains the lack of accuracy in forward earnings estimates? Quite simply, analysts are overly optimistic. Forward earnings are, on average, about 10% higher than subsequently realized earnings. However, this excess of optimism is not stable over time or across stocks. Paul Hribar and John McInnis show that analyst overoptimism rises when investor sentiment is buoyant — particularly for growth stocks with hard-to-estimate future earnings. And recent research by Ulrike Malmendier and Devin Shanthikumar demonstrates that while analysts on average are overly optimistic, those affiliated with an underwriter of a company's securities tend to be strategically overoptimistic and thus systematically distort their forecasts.

Of course, Ben Graham, the founder of value investing, knew this a long time ago. In The Intelligent Investor, he wrote, “While enthusiasm may be necessary for great accomplishments elsewhere, on Wall Street it almost invariably leads to disaster.”

In the spirit of dumb alpha, then, we can say that simple trailing P/E ratios are far better value indicators than forward P/E ratios. Or as I tell my colleagues at work: "Never ever use forward P/E ratios. Ever."

For more from Joachim Klement, CFA, don’t miss Risk Profiling and Tolerance: Insights for the Private Wealth Manager, from the CFA Institute Research Foundation, and sign up for his regular commentary at Klement on Investing.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author's employer.

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