A Better P/E Ratio for the Recession

You know what a P/E ratio is, right? It's basically a fraction, a company's stock price divided by its earnings per share (EPS) for the previous 12 months.

Consider Acme Explosives Co. (ticker: KBOOM), trading at $50 per share. If its EPS for the last year is $2.50, you just divide $50 by $2.50 and get a P/E ratio of 20. If the stock price stays steady and the EPS rises, the P/E will fall -- and vice versa. For example, a stock price of $50 and an EPS of $5 yields a P/E of 10. You can calculate P/E ratios based on EPS for last year, this year, or future years.

In general, the lower the P/E ratio, the more attractively valued a stock is.

We usually look at P/Es based on past earnings, but I think we'd be better off looking at "forward" P/Es, based on the coming years' expected earnings.

Screen it forward
Let's see how it can help you. In a recession, if you look at trailing P/Es, then you'll often find lower values than if you look at forward P/Es. That's because trailing earnings don't yet reflect the impact of the recession, and forward earnings will often fall.

But that doesn't mean that all companies are doomed to see their P/E ratios rise over time. For instance, I did a screen looking for companies with 5-year past earnings growth of 10% or more and a forward P/E value that's both less than 10 and lower than the current P/E. Here are some of the results:

Data: Yahoo! Finance.

Look at Zimmer as an example. If you screened for current P/Es under 10, you'd have missed it, though its forward P/E is under 10. (That difference suggests expected earnings growth.)

When you study companies, give forward P/Es some consideration (while acknowledging that there's much more to undervalued stocks than just P/Es).