In the investment world, we love goals to measure, compare, and even consider sacred. One of the most sacred is the price-to-earnings ratio, which is defined as the stock price divided by the net income per share. The higher the PE ratio, the more likely investors are to believe that the company will generate strong earnings growth in the future that will justify the current price. For example, if a company’s stock price is $30 and its earnings per share (EPS) is $1.00, its current price-to-earnings ratio is 30x. If EPS growth is expected to be 50% next year and 40% the year after, the stock should only sell for 14.3x earnings two years from now. The market is willing to pay a premium for future net income growth. On the other hand, if a stock currently sells for $30 and has an EPS of $1.50 this year, its PE is 20x. With only 5% earnings growth expected per year, the 2-year PE is 17.6x. Even now, with earnings up 50%, the market values it at the same level as previous examples with higher growth. The S&P 500 is currently trading at its highest multiples ever, 22.6x 2024 expected earnings and 21.1x 2025 expected earnings. Even excluding the technology sector, which trades at a robust 30.8x earnings, the market PE is a robust 18.3x next year’s earnings, according to FactSet. At these levels, it’s very hard to find attractive, undervalued stocks. One place investors comb through is a list of stocks with low PEs. Investors believe that these stocks are “cheap” and therefore offer attractive value. There is often an assumption that if a stock is selling at a multiple at the low end of the 10-year PE range, it must be a real bargain. Are “cheap” stocks really bargains? There are two reasons why I don’t think this makes much sense. First, growth stocks can have high double-digit earnings growth rates when they are in the early stages of expansion. This includes technology and communications companies like Microsoft, Apple, and Alphabet, but also consumer goods companies like Nike and Lululemon. During their rapid growth, these companies can command PE ratios well above 50 times current earnings. Over time, the multiple often declines, reflecting lower expectations for net earnings growth. Second, the opposite is true: cyclical stocks can sell for their lowest PE when earnings are at their peak. At that point, earnings may be about to decline, which can often coincide with a slump in stock prices. But my thesis was pure speculation. It’s time to dig into the data and test my hypothesis. “Cheap” Stocks Don’t Always Outperform I looked at statistics for the top 100 S&P 500 index constituents over a five-year period, using their PE to current earnings, excluding stocks for which PEs are unavailable due to losses. We compared each stock’s year-end PE to its 10-year average to come up with a ratio that shows how its current valuation compares to the past. A ratio of 2 means the stock is currently trading at twice its 10-year average PE, while 0.5 means its PE is half its historical multiple. We then grouped these stocks into quintiles based on their relative PE ratios, from highest (1st quintile) to lowest (5th quintile). We used 2015 to 2019 to collect a somewhat broader dataset, with the understanding that the 2019 cohort would be affected by the pandemic. To determine whether a lower relative PE correlated with subsequent outperformance, we calculated the average compounded return over the following four years for each quintile. We then ranked the returns of these quintiles by year, from highest (1) to lowest (5). The data is in the table below. The data shows that despite lower PE levels compared to the past, the lowest cohort of stocks has performed worst in three of the five years observed. The best performing quintile is third, likely because the stocks have maintained their growth trajectory. These stocks are not overvalued at current valuations and do not show any obvious signs of earnings decline. This evidence seems to negate the idea that stocks with low relative PEs are fertile ground for attractively priced stocks, at least for the years observed and for the top 100 stocks in the S&P 500. It is never a bad thing to test a theory that may be flawed. We may learn something new that challenges conventional thinking. Karen Firestone is Chairman of the Board and Co-Founder of Aureus Asset Management, an investment firm dedicated to providing modern asset management to families, individuals and institutions.
Traders working on the floor of the New York Stock Exchange
New York Stock Exchange
In the investing world, we love goals to measure, compare, and even treat as sacred. One of the most sacred goals is the price-to-earnings ratio, defined as the stock price divided by the net income per share.
The higher the price-to-earnings ratio, the more investors believe the company will generate strong earnings growth in the future, justifying the current price.
