When screening for investments, I often like to look at the forward price-to-earnings ratio as a metric that gives me an estimated glimpse into a company’s future earnings power relative to its current price. If I find a disconnect — when a company looks expensive when considering its trailing P/E ratio but fairly valued or even cheap when looking at its forward P/E — I pay a little more attention and dig deeper.
If the company has a bad quarter or a one-time item or charge that depressed earnings, I often like to determine if the problematic earnings are likely to be an ongoing trend or just a unique, isolated incident that is making a company look more expensive than it is compared to its more normalized earnings. Below are three companies that may currently meet this criteria.
A telecommunications giant
With a trailing P/E ratio of around 29, AT&T Inc. (NYSE:T) looks ridiculously expensive. But is this the case?
After problematic earnings attributed to factors such as underfunded pension problems (which caused a big drop in earnings), AT&T Inc. (NYSE:T)’s true earnings power is being temporarily depressed — giving the company an abnormally high P/E, as well as an abnormally high payout ratio of well over 100%. Some people are screaming that the dividend isn’t safe because of this “unsustainable payout ratio.”
Looking forward, with more normalized earnings (earnings that aren’t plagued and dragged down by one-time charges and more temporary problems) in mind, another picture emerges. Analysts expect AT&T Inc. (NYSE:T) to earn $2.52 per share going forward, giving the company a cheap forward P/E ratio of only around 14. This also brings the company’s payout ratio going forward to a much more sustainable level of around 70%.
A triple-A rated medical company…
Another company that faced a temporary drop-off in EPS was Johnson & Johnson (NYSE:JNJ). This drop-off was largely due to $1.24 per share in non-recurring items. Remove this temporary anchor on earnings and then the company would be seeing more normalized EPS of $5.10. Unfortunately, due to the special items, Johnson & Johnson (NYSE:JNJ)’s EPS were only $3.68 — giving the company a trailing P/E of around 23.
Considering the company’s annual EPS estimates of $5.41 going forward, however, Johnson & Johnson (NYSE:JNJ) looks much more attractively valued at current levels– with a forward P/E of around only 15.