Don't Fall for the Disappearing Earnings Trick

Everyone's trying to figure out when investors will stop panicking. Yet even as the bear market worsens, signs of weakening earnings are curbing any optimism about a potential economic recovery in the near future.

As early as the beginning of 2007, many analysts believed that any market downturn would be short lived and limited to homebuilders and small lenders. However, as the credit crunch has spread from the subprime niche to threaten mainstream financial institutions like Lehman Brothers and Washington Mutual, concerns about the effect of the crisis on future profits have lingered. Now, with no end in sight to the continuing fall in housing prices, company executives seem reluctant to try to forecast when the all-clear signal for the economy as a whole will appear.

What will the future bring?
For the most part, companies have been reporting fairly positive results for the second quarter. In some industries, such as telecom and industrial stocks, nearly 90% of companies have beaten analyst estimates. More importantly, most industries have seen earnings grow from last year's levels.

Yet often, companies have reported good past financial results but at the same time warned about the prospects for future earnings. When this happens, investors are disappointed, and stocks prices often go down despite the favorable earnings report. In turn, this causes their trailing P/E ratio to drop. If you focus entirely on historical earnings, therefore, you'll see valuations on these stocks becoming even more attractive than you'd guess if you looked only at the falling share price.

The importance of future earnings
Yet this divergence exposes one of the weaknesses of looking solely at historical P/E ratios. When earnings projections drop, forward P/Es can actually rise even if shares drop. Past results can shed some light on a company's prospects for the future, but it's far more important to a stock's valuation to know how much money it will make in coming years. If profits are slated to fall, investors should focus on valuations based on future earnings to make sure they don't mistakenly assume a company is attractive.

Consider, for example, the following companies -- all of which have forward P/E ratios that are greater than their current trailing P/Es:

Source: Yahoo Finance.

In assessing whether these stocks are good values, it makes a crucial difference which P/E ratio you use. From their trailing P/Es, these companies look relatively cheap. Yet a look at forward P/E ratios tells you that they aren't necessarily going to look inexpensive a year from now, even if their share prices stay at current levels. Often, the conclusions you draw will be much different depending on how much weight you give to past results versus future projections.

Which is best?
Most investors are more familiar with trailing P/E numbers, simply because you can find them everywhere. Most newspapers and online quote services tend to provide trailing P/E numbers, making them easier to find than forward earnings projections. Especially if you go back a number of years to see where the current trailing P/E ratio fits into the company's historical range of P/Es, you can get a good sense of whether the company is doing relatively well or poorly compared to its past performance.

But doing the minimal extra work involved in finding forward earnings estimates adds quite a bit. Trailing P/Es using actual earnings can be skewed by one-time charges and other extraordinary items, but analyst estimates more often pinpoint operating earnings from continuing business. Of course, one shortcoming of forward earnings is that they're only as good as the analysts making the projections, and those projections often change substantially in relatively short periods of time.

Overall, using both historical and forward P/E figures to guide your investment decisions makes sense. Understanding how they are interrelated can help you gain deeper insight into both a company's past and its future.

For more on how to invest in tough times, read about:

• Why now's the best time to invest in a decade.
• Stocks you can buy and hold for the next 4 years.
• What Fannie and Freddie mean to you.