A very interesting study was carried out in 2009 by Wan-Ting Wu, at the Arizona State University. The paper was called The Forward P/E Ratio and Earnings Growth. His research shed provided edification on how to use forward P/E ratios to more anticipate future realized growth.
Finding: forward P/E ratios only correlate strongly to future realized earnings growth when looking at 5 years or longer.
Oddly enough, forward P/E ratios had very little correlation to short-term earnings growth over the next year or two. A better correlation was made between forward P/E ratios and sales growth.
Forward P/E Ratios and Earnings Risk
Finding: very high and very low forward P/E stocks had the highest amount of earnings risk.
Very high earnings expectations, as reflected in the lofty forward P/E ratios, were often missed. This was also true of low forward P/E stocks. The risk of missed earnings was also extremely high in low forward P/E ratio stocks, which some value investors assume are the safer bets.
Negative Growth and Forward P/E Ratios
The study found that during periods of negative earnings growth, forward P/E ratios provided fairly reliable indications of future earnings growth over the next 2 years. If current earnings growth is positive, then the foreword P/E ratio would be a good indicator of future earnings growth over the next 5 to 10 years.
The Forward P/E Scan
Based on Wan-Ting Wu’s findings, we can screen for high future earnings growth stocks (over the next two years) by the using the following scanning criteria:
- Negative earnings growth over the past 5 years
- Negative earnings growth so far this year
- High forward P/E ratios greater than 35
- Average daily volume over 1,000,000 shares
I should make in clear that Wan-Ting Wu did not specify the numerical inputs; I am creating these myself based on his research. This will add subjectiveness. If his research is accurate, this should increase our odds of finding a stock that will experience high future earnings growth over the next 2 years with reduced risk.
The List of Stocks
A list of 15 stocks came up in my scanner. Before I outline which they are, note that the following sectors and countries they were in:
- 5 stocks in Basic Materials sector related to oil and gas, but also gold. 7 on the list are from the financial sector of which 4 are REITs. 3 stocks in service sector with staffing, lodging, and advertising industries.
- Furthermore, 12 of stocks came from the USA and 3 from Canada.
Here is the list of 15 stocks:
- Robert Half International Inc. (RHI)
- Starwood Hotels & Resorts Worldwide Inc. (HOT)
- Monster Worldwide Incorporated (MWW)
- AMB Property Corp. (AMB)
- Zions Bancorp. (ZION)
- Whitney Holding Corp. (WTNY)
- Host Hotels & Resorts Inc. (HST)
- Sterling Bancshares (SBIB)
- Kimco Realty Corp. (KIM)
- DiamondRock Hospitality Co. (DRH)
- Range Resources Corp. (RRC)
- EnCana Corp. (ECA)
- Enerplus Resources Fund Trust Units (ERF)
- Northgate Minerals Corp. (NXG)
- SandRidge Energy Inc. (SD)
As could be expected with negative growth companies with high forward P/E ratios,6 companies expected triple digit growth next year; one even expects 1300% EPS growth next year. 8 of the companies have institutional ownership of 80% or greater. 8 companies have the float short of 7% or higher.
A big surprise comes with performance. I expected share prices to be in steady decline. To my shock, all the share prices but one grew significantly over the past quarter to half a year.
- 8 of the stocks are over 20% higher in price over the past quarter.
- The S&P 500 is only up about 12% over the past 3 months.
- The average analyst rating was 2.5 out of 5, or slightly above a 3 hold rating.
The findings in the report came somewhat as a surprise as I always imagined that forward P/E ratios were decent measurements of realized growth. If his study is correct, and I am assuming that it is, then this means forward P/Es in positive EPS growth stocks is a poor selection method of accurately accessing future absolute growth numbers when projecting less than 5 years.