Way back in the 1980s, a video game called Pitfall! had us searching for buried treasure in a virtual jungle. Fast-forward a few decades and we're still chasing that buried treasure -- only now, the search is happening in the real-life financial markets, and we're leaning on valuation metrics to point us in the right direction.

One of those metrics that can help locate hidden gems is the price-earnings ratio. Also known as price multiple or earnings multiple, the P/E ratio is derived by dividing the company's stock price by its earnings per share (EPS) over the last 12 months. The result tells you the price investors are willing to pay for every $1 of earnings. Investors use it to make comparisons between peers, and to gauge whether a stock is overvalued or undervalued. A higher P/E ratio could mean the stock is overvalued or that investors believe that the company's earnings will rise. A lower P/E ratio indicates that the company is either undervalued or that investors expect its earnings to fall.

Man looking at three investment screens.

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The problem of historic earnings

You can use P/E ratios to find good buys, but the metric has its weaknesses, particularly in a recession. The big drawback is that it uses the company's previous 12 months of earnings. Early on in the recession, historic earnings will be indicative of performance when times were good -- but that is likely to be much different from what will actually happen as the company works through the downturn.

Plus, those historic earnings figures are only updated periodically throughout the year, while the numerator in the P/E ratio -- share price -- fluctuates daily. That share price will immediately reflect recessionary conditions. The result? Inflated earnings and a lower share price will drive P/E ratios down.

As an example, Macy's (M -0.66%) P/E ratio at February 1, 2020 was 8.76, derived from EPS of $1.82 and a price per share of $15.95. As of May 20, 2020, the retailer's stock price had dropped to $5.07 in the wake of the coronavirus pandemic. Updated earnings aren't yet available, so the current P/E ratio, calculated with the same $1.82 EPS figure, is now down to 2.8.  

At the end of a recession, the opposite happens. Previous earnings will be down relative to how the company should perform when the economy is on the rebound. But stock prices will recover quickly. The combination of deflated earnings and higher stock prices will drive P/E ratios up.

An alternative metric 

An alternative stock valuation metric that somewhat addresses these issues is the forward P/E ratio, which swaps the company's projected earnings into the calculation instead of its actual recent earnings.

This approach makes sense on paper. A company's historic performance often doesn't reliably predict its future anyway, whatever the economic climate. The biggest challenge for the forward P/E ratio, however, is that its value as a guide is dependent on the accuracy of the company's earnings projections. That's why many analysts prefer to use the trailing P/E ratio -- it's simply more objective.

Earnings projections are subjective and constantly evolving based on market conditions. Companies may overstate or understate their outlooks to manage public opinion. As well, analysts generate their own earnings estimates that usually differ from the company line. And finally, as in the case with Macy's, earnings projections could be negative, which results in no forward P/E ratio at all.  

Splitting the difference

For the most accurate view of a stock's price relative to earnings in a recession, the best practice is to consider both its trailing and forward P/E ratios. You can still use trailing P/E to compare peer companies in the same period, since the recessionary impacts on them should be similar. Just don't rely on trailing P/E to make quarter-to-quarter comparisons, or to make investing decisions based on it rising above or falling below a certain value.

As for forward P/E, it can help you understand whether a stock is undervalued or overvalued even as the economy works through hard times. But because forecasts can change, keep close tabs on your companies and reassess them periodically. Updated forecasts will change their forward P/E ratios, which might alter your stance on them.

In Pitfall!, you had to make your avatar jump over logs and crocodiles en route to the hidden treasure. As an investor, you're navigating through changing economic climates and metrics that can lead you astray. Give yourself the best shot at success by casting your research net wide and reacting quickly as new information becomes available.