In the investment world, the price-to-earnings ratio (PE ratio) is considered a sacred measurement used to evaluate stocks. It is calculated by dividing a stock’s price by its net income per share. A higher PE ratio indicates that investors believe the company will experience significant earnings growth in the future, justifying the current price. For instance, a stock priced at $30 with earnings per share of $1.00 would have a PE ratio of 30.
With the S&P 500 trading at an all-time high multiple of 22.6 times estimated 2024 earnings, investors are finding it challenging to identify attractive, undervalued stocks. Many investors turn to low PE stocks, assuming that they offer good value because they are considered “cheap.” The belief is that if a stock is trading at the lower end of its 10-year PE range, it must be a bargain. However, this assumption may not always hold true.
Contrary to popular belief, ‘cheap’ stocks do not always result in outperformance. When analyzing the 100 largest stocks in the S&P 500 over a five-year period, it was found that stocks with low relative PE ratios did not necessarily perform better. In fact, the lowest cohort of stocks, despite trading at historically low PE levels, underperformed in three out of five years. This challenges the idea that low PE stocks are a surefire way to find attractive investments.
Digging into the Data
To further test this theory, the data was analyzed to determine if low relative PE ratios correlate with subsequent outperformance. Stocks were grouped into quintiles based on their relative PE ratio compared to their 10-year average. The analysis spanned from 2015 to 2019, providing a comprehensive dataset. Surprisingly, the results showed that the stocks with the lowest PE ratios did not consistently outperform the market.
In the world of investing, it is crucial to challenge conventional wisdom and test theories that may be flawed. The data presented debunk the notion that low PE stocks always offer attractive investment opportunities. Investors should not rely solely on PE ratios to determine the value of a stock, as other factors play a significant role in a company’s performance.
While the price-to-earnings ratio is a valuable metric for evaluating stocks, it should not be the sole determinant of investment decisions. ‘Cheap’ stocks may not always be a good deal, as demonstrated by the data analysis. Investors should consider a holistic approach to stock evaluation, taking into account factors beyond just PE ratios. Challenging conventional thinking and testing assumptions is essential in the ever-changing landscape of finance.