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When calculating PE ratios in real life, it is easy to find a company’s share price, but what figure should we use for EPS? For example, should we use the company’s earnings from last year or its forecast earnings for this year? Because of the different values of EPS that can be used, there are three basic types of PE ratio. All are based on the current price, but one is based on previous earnings, one is based on forecast earnings and one is based on average earnings.

1 Trailing PE: This is based on the actual earnings for the previous 12 months and is sometimes referred to as the historic PE.

2 Cyclically adjusted PE: This uses earnings averaged over periods as long as ten years; often referred to by its acronym CAPE.

3 Forward PE: This is based on the forecast earnings for the coming 12 months and is often referred to as the forecast PE.

The following table gives some sample real-life data for trailing and forecast PEs:

Company	Share price	Trailing EPS	Trailing PE	Forecast EPS	Forecast PE
ARM Holdings	545	6.44	84.6	9.96	54.7
Aviva	434	50.40	8.6	64.55	6.7
Severn Trent	1441	130.64	11.0	92.56	15.6
Tesco	388.5	26.29	14.8	32.72	11.9

For example, in the previous 12 months Tesco had an earnings per share of 26.29p, and at the time of writing its share was 388.5p; therefore its trailing PE was 14.8 (388.5/26.29). However, for the coming 12 months Tesco has a forecast EPS of 32.72p, which gives it a forecast PE of 11.9 (388.5/32.75).

So which is best?

Different people have different views. The trailing PE is one that is quoted most often in the financial press. The main advantage of this method is that you are dealing with facts, not forecasts. The CAPE has had, and still has, its followers; some notable ones include Benjamin Graham and Robert Shiller. The advantage of the CAPE is that it eradicates the possibility of the ratio being distorted by one year’s figures. A moving average over a minimum of five years should mean that the sample period includes at least one complete economic cycle. And this measure is supported by the logic that company and index ratings will in time revert to their mean.

While both of the preceding have merit and cannot be dismissed lightly, my first point of reference will always be the one year forward PE.

Although the trailing PE is based on verified figures, you don’t drive a car by looking in your rear view mirror, therefore I prefer this year’s forecasts to last year’s facts. The same comment applies to the CAPE but even more so. There is no doubt the CAPE will eradicate the chance of one set of figures giving a misleading reading, and although CAPE may be ideal for long-term financial studies, I cannot accept that earnings figures that could stretch back over a decade ago should play a part in tomorrow’s investment decision. The market itself is a forward looking animal. It’s a barometer, not a thermometer, and will always discount ahead. It therefore makes sense to use a measure that does the same.