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How can you use the P/E ratio to forecast the price of a stock

In practice, there are two different kind of analysts. Those that believe in technical analysis and those that believe in fundamental analysis. Technical analysts try to identify patterns that are based on historical events (the past of a stock) which are then used to forecast the future movements of a stock.

An easy method that technical analysts use to forecast the stock price is the Price to Earnings ratio (P/E ratio). The Price to Earnings ratio can be easily calculated by dividing the price of the stock (the market value) by the earnings per share of the stock. An another way to divide the total market capitalization of a company by the total reported earnings.

So how can you use the P/E to develop for a forecast for the price? You collect the reported earnings along with the number of shares that the company had issued. This can be easily done by downloading the annual reports from the company’s website or from the Securities and Exchange Commission.

You will need the reported earnings (the final figure that you can see on the income statement). You will also need the total number of ordinary shares in issue. You can also use the annual report to get this balance.
The last thing you will need is the market price of one stock. Some people use the price at the date that the annual report was issued. I prefer to use the average price for the week after the annual report was issued.
Finally, you will need is excel. Excel has a function that is called “linest” which is the acronym for linear regression. By using this function, you basically try to find a single line that best described the relationship between the price of the stock and the earnings that the company reported.

The steps that you should follow are the following:

  • Include the reported earnings in the Column A
  • Include the price of the stock in Column B
  • Click the Fx button and search for “linest”
  • Use the Price as the “known Ys” and the earnings as the “known Xs”.
  • Put False in the other two boxes.
  • Click ok and excel should have calculated a number for you.

You can use this number to forecast what the price will be if you know the earnings. You simply multiply this number with the earnings you have and this is your forecast. One of the applications of this method is to try to forecast the price movement if you have a forecast for the reported earnings. You can get forecasts from professional analysts reports.

Finally a disclaimer! Most people would agree that there is no safe and accurate way to predict stock prices. This is particularly true when you use one single metric (the P/E). Apart from that, the reported earnings is an accounting figure which means that by using a figure that is based on accounting policies and which includes income and expenses that might be one-off will definitely not give you an accurate forecast.

Apart from that, the stock price can be affected by many things some of which are hard to be identified and some of which are hard to be measures and quantified.

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