The investment world often relies on various metrics to evaluate and compare different stocks, with one of the most revered being the price-to-earnings ratio (PE ratio). The PE ratio is calculated by dividing a stock’s price by its net income per share. It is believed that the higher the PE ratio, the more potential there is for the business to deliver robust earnings growth in the future.
Currently, the S & P 500 is trading at historically high multiples, with the overall market PE ratio sitting at around 22.6 times estimated 2024 earnings. Finding undervalued stocks in such an environment can be a challenging task for investors. One common strategy is to look for low PE stocks, assuming that they offer attractive value simply because they are ‘cheap’.
However, the idea that low PE stocks always represent a good deal may not hold true in all scenarios. Growth stocks in their early expansion phase can command high PE ratios, while cyclical stocks may have low PE ratios at their peak earnings, signaling potential declines ahead. To truly understand the relationship between PE ratios and stock performance, it is necessary to dig deeper into the data.
A study was conducted on the 100 largest stocks in the S & P 500 over a five-year period, comparing their current year PE ratios to their 10-year averages. The stocks were grouped into quintiles based on their relative PE ratios, ranging from the highest to the lowest. The analysis aimed to determine whether low relative PE ratios correlated with outperformance over the following years.
Contrary to popular belief, the data revealed that stocks with the lowest relative PE ratios actually performed the worst in three out of five years. On the other hand, stocks in the third quintile, which maintained their growth trajectory, emerged as the top performers. This challenges the notion that low PE stocks are always a good buy and highlights the importance of a more nuanced approach to valuation.
The study results suggest that blindly investing in ‘cheap’ stocks based on low PE ratios may not lead to superior returns. It is crucial for investors to analyze individual company fundamentals, growth prospects, and market conditions before making investment decisions. While PE ratios can be a useful tool for valuation, they should not be the sole determining factor in stock selection. By challenging conventional thinking and testing assumptions, investors can gain a deeper understanding of market dynamics and potentially uncover hidden opportunities.