The stock market is a forward-looking machine, with a motor that just won't quit. So when it comes to figuring out whether a stock is worth buying, investors care most about where profits are headed, not where they've been. That's why Wall Street's preferred metric to value companies is the forward price-to-earnings (P/E) ratio. It's a tough break for its cousin, the trailing P/E. But the market has made up its collective mind. In this equation, the "P" stands for the company's current stock price, and the "E" is the analysts' estimated earnings per share (EPS) for the next four quarters. Trailing P/Es have their place. After all, this measure is calculated using actual earnings over the previous 12 months — not an estimate of future results. In a recent piece, the Investing Club went into detail on how to calculate P/Es and other considerations on valuation. Here's a quick refresher: Let's say a company has a stock price $250 and a 12-month trailing EPS of $10. You calculate the trailing P/E ratio by dividing stock price ($250) by trailing P/E ($10) — or $250/$10 — to get 25. That means the stock is currently trading at 25 times the EPS of the past year. With trailing P/Es, investors can use them as a means of grading management: Did the team execute on its stated objectives? Does the company have a history of hitting growth targets? They also serve as a great tool for comparing a company's valuation versus its industry or sector peers, or against its own historical valuation. You can also compare the trailing P/E against the forward P/E to get a sense of its future expected growth. If the trailing P/E is greater than the forward P/E, it points to earnings growth ahead; if the trailing P/E is less than the forward P/E, it means that earnings are projected to fall. But fundamentally, investing is all about owning a piece of a company's future earnings, so the forward P/E is the standard way to value stocks. The market is a discounting mechanism, which means its prices already reflect all known information. When new developments happen, even sudden ones, the market "discounts" — or takes into consideration — them to come up with a new value. In other words, the market doesn't care so much about the past. The goal of many investors is to find the next Amazon or Apple . Or, at the very least, the goal is to invest in Amazon or Apple before they become even more profitable and, as a result, see their share prices rise. We're always looking to buy low and sell high. The "bet" is almost always on future earnings being higher than past earnings. The risk of investing this way, of course, is that the future earnings are inherently a prediction and not yet realized (unlike trailing earnings). You're making your best assessment that a company can at the very least meet, or better yet, exceed its internal earnings projections — and Wall Street's own expectations. If that happens, the stock will usually rise as a result. As the saying goes, stocks follow earnings. Should investors worry about the credibility of those estimates? While management could be overly optimistic in its guidance, the estimates Wall Street uses come from teams of research analysts whose job is to be accurate, not hopeful. If the analysts are consistently overestimating a company's future results and setting investors (their clients) up for disappointment, they won't be analysts for long. Investors will also quickly pick up on companies that overpromise and underdeliver — and yank their funds from the stock. A loss of investor confidence in management is about as bad as it can get for a company's stock. After all, nobody wants to be in the car with an unreliable driver. If you were going to purchase a local business, such as a bakery, you want to learn about its historic sales and profits to determine demand for its cakes and pastries, customer loyalty, ingredient cost dynamics, and so on. However, as you think about how much to pay for it, you'll want to know how long it will take to make your initial investment back (the breakeven point), and then at what rate you'll be making a return on that investment. You can only do that my making an assumption of future profits. Whether the profits are growing over time or remain relatively stagnant (usually the case with a more mature business), will inform you as to how much you should pay for the business. Bottom line Investors should put greater weight on future earnings because, well, they are investing in the future. While there is certainly the risk that management or Wall Street research analysts could be too optimistic in their outlook, the incentive is to be right, not hopeful. That doesn't mean we can be asleep at the wheel and not do our own analysis of a company's earnings potential. However, it does mean that while investors may at times be against one another — the bull-versus-bear debate, so to speak — everyone aside from management is trying to do the same thing: estimate future earnings and determine whether the general consensus is too high, too low or right on the mark. CEOs and CFOs, meanwhile, need to be accurate in order to maintain credibility, which is essential to maintaining investor confidence. Their jobs are on the line.
