Analysts Usually are Wrong

This article has an interesting exercise. The author asks whether a value stock investor should use the historic price-earnings ratio or the forward (or forecast) price-earnings ratio to decide whether a stock is cheap. Many studies have shown that using historic data and buying the cheapest stocks delivers a higher return than the market indexes or the most expensive stocks. But the author found that the advantage of picking value stocks disappears when forward P-E ratios are used.

Why don’t forward P/E ratios work as a measure of value? The answer is rooted in analysts’ estimates of future company earnings. As I demonstrated in the second installment of this series, analysts are terrible at predicting interest rates, exchange rates, or stock market performance over the coming 12 months. And they are similarly inept at predicting company earnings. In fact, using trailing 12-month earnings is typically a better predictor than analyst-estimated forward earnings. This is why trailing P/E ratios do a better job at selecting value stocks than forward P/Es.