The Forward P/E Ratio and Earnings Growth

Abstract:     
This paper examines the association between the price-to-forward earnings ratio (i.e., the forward P/E ratio) and subsequent realized growth. Investment practice, as well as an elementary model like the constant growth model, suggest that the forward P/E ratio depends on expected growth and risk. If investors' growth expectations are rational, a positive correlation should be observed between the forward P/E ratio and subsequent realized growth, holding risk constant. I find a nonlinear relationship between the forward P/E ratio and subsequent realized growth, whether risk is held constant or not. While firms in the highest forward P/E portfolio are most able to deliver extremely high growth, they also report losses the most frequently. My findings also suggest a U-shaped relationship between the forward P/E ratio and volatility of earnings growth. Compared to firms in the lowest forward P/E portfolio, which are inherently financially distressed, firms in the highest forward P/E portfolio are more likely to report losses and have higher volatility of earnings growth. Further analysis shows that the earnings growth of firms in the highest forward P/E portfolio is not sufficient to justify their high valuation in the base years.

Keywords: Forward P/E ratio, Earnings growth

JEL Classifications: G12, G14, M41

Working Paper Series