Fair Value (FINBOX)

Forward Price-to-Earnings ratio, Forward P/E Multiple, or Forward P/E Ratio is valuation multiple that is defined as:

P/E Ratio = Market Capitalization / Forecast Net Income

or, using per-share numbers:

P/E Ratio = Stock Price / Forecast Earnings Per Share (EPS)

P/E Ratio indicates the multiple of earnings investors are willing to pay for one share of the company. PE Multiples are widely used in practice even though they have significant pitfalls.

Since Earnings Per Share (EPS), defined as Forecast Net Income / Shares Outstanding, uses a Forecast Net Income in the calculation, P/E multiples are not always reliable for benchmarking companies with negative earnings or debt.

One reason why P/E ratios can be unreliable is because the ratio assumes a company’s equity has value. In practice, a company’s total Firm Value may be less than the debt on its Balance Sheet, with no value allocatable to the common equity. P/E ratios also do not adjust for differences in capital structure between companies. P/E conundrum by Khan Academy does a great job of explaining these pitfalls.