Trusting the Financial Planning Department
Traders often spend considerable time trying to predict a company's future earnings. They will create these complex spreadsheets that analyze a multitude of variables, from the company's competition to the predicted federal interest rates.
These analyses provide a level of comfort to the trader; he believes that his analysis is so thorough and complex that it must be correct.
Was his analysis worth the time spent creating it? Probably not.
Most publically traded companies perform this same analysis and communicate it to shareholders. You can see the results for yourself; take a look at the company's Forward P/E ratio.
Comparing the Trailing P/E ratio to the Forward P/E ratio illustrates how the company predicts its earnings to change in the future. If Forward P/E is much higher than the Trailing, this means the company predicts a higher P/E (or lower earnings) going forward.
If the Forward P/E is much higher than Trailing, you may not want to invest. Done. Your analysis is complete.
Some traders argue that a company's projections may be overstated, thus reliance cannot be placed on the Forward P/E. While it is true that any company may misstate earnings projections, you must consider that its Financial Planning Department is involved in the daily business activities. They know the company inside and out - much better than any person trading from his home.
It is near impossible that the average trader will be able to create an analysis even close to the thoroughness and accuracy of a company's Financial Planning Department. There are too many variables that affect a company's projected earnings; trying to predict these without being involved in the company's daily operations is a losing game.
As traders with a life, we need to learn to trust the Forward P/E ratio as we trust the entire SEC filing process - from the initial business transactions all the way to the external auditor signoff of the financial statements.
Spending too much time trying to predict the future will only distract from the big picture - quickly identifying and compounding our profits.