an awareness of the problems of core earnings adjustments in
a particular company. Given that the majority of trading-dol-
lar volume takes place among institutional investors (where
we also assume that a sophisticated level of analysis takes
place), it is reasonable to assume that this awareness does, in-
deed, affect price volatility. At the very least, it is an idea worth
keeping in mind as we try to understand the relationship be-
tween market price trends and core earnings adjustments.
Balancing PE and Market Perceptions:
Looking to the Future
In using PE ratio as a primary test, we can also learn a lot about
how the market generally perceives a stock’s value. There is a gen-
eral sense that higher PE means higher growth potential. In prac-
tice, however, PE ratios higher than average have historically
underperformed market averages, and stocks with lower than aver-
age PE have performed better than market averages. Many investors
would assume just the opposite.
The purpose of using PE as one of our analytical tools is to try
to get some idea of the company’s growth direction and rate. The
comparison between current price and a series of quarter-ending
earnings is also aggravated by the fact that quarterly reports often
do not reflect adjustments that should be made. A full audit at year-
end may reveal substantial timing differences, income recognition
problems, and other accounting decisions that distort interim re-
ports. We need the audited year-end numbers to establish long-term
trends and to make an attempt to look to the future. At the same
time, we have to recognize the limitations of PE as a reliable indi-
cator. It is useful to confirm other information about both price and
financial values; but using the PE to attempt a calculation of future
growth is too far removed from the reliable information we need to
make informed decisions.
PE as it is usually applied may also be called the trailing PE be-
cause it is based on comparisons between current price and previ-
ously reported EPS. Another variation, called anticipated PE, or
forward PE, is an attempt to identify likely PE levels in the future.
Trailing PE is based on established price and earnings values, so in
comparison, it is at the very least an objective form of the ratio. For-
ward PE is based on an estimate of future earnings and future price.
So, using a target for both sides of the equation means that forward
PE can be made to appear any way we want. Both sides are esti-
mates, but if even one side is wrong, the entire ratio is unreliable. For-
ward PE, because it combines earnings estimates and price targets,
is a dubious form of the ratio.
This raises a related question: What is the purpose of perform-
ing forward PE? We begin with the premise that trailing PE is flawed
because it compares current price to historical earnings, those earn-
ings were not audited, and no core earnings adjustments were made.
Why would we want to make an estimate about PE in the future? If
we think about what the ratio reveals, then we also realize that it pro-
vides no tangible value. PE is a reflection of the market’s perception
about growth potential; the multiple of earnings reflected in price
provides us with a comparative view of how price relates to actual
earnings. In trying to track PE into the future, we make a broad as-
sumption about perception, even though we cannot know what that
perception will look like six, nine, or 12 months from now. We are
better off staying with the more reliable trailing PE, even with its
limitations as an indicator.
The predictability problem is not limited to the unknown future
earnings and market price levels; The problem is aggravated when
the price is more volatile than we would like. If PE has been highly
unpredictable due to price volatility, then its value as an indicator will

Get Stock Profits: Getting to the Core—New Fundamentals for a New Age now with O’Reilly online learning.

O’Reilly members experience live online training, plus books, videos, and digital content from 200+ publishers.