The investment world loves benchmarks to measure, compare, and even hold sacred. One of the most hallowed ratios is the price-to-earnings ratio, defined as the stock price divided by the net income per share. The higher the PE ratio, the more investors believe the company will generate strong earnings growth in the future to justify today’s price. For example, if a company’s stock price is $30 with earnings per share (EPS) of $1, the company has a current price-to-earnings multiple of 30. If EPS growth is expected to be 50% next year and 40% the year after that, the stock is selling for just 14.3 times earnings over the next two years. The market is willing to pay a higher price for future net income growth. On the other hand, a stock currently selling for $30 with an EPS of $1.50 this year has a PE of 20. With earnings growth expected at just 5% per year, its two-year projected PE would be 17.6 times. Even if earnings were to grow by 50% today, the market would still be priced in the same range as the previous example with higher growth. The S&P 500 is currently trading at an all-time high of 22.6 times estimated 2024 earnings and 21.1 times estimated 2025 earnings. Even excluding the tech sector, which trades at a high 30.8 times earnings, the market PE would still be a solid 18.3 times next year’s earnings, according to FactSet. At these levels, hunting for attractive but undervalued names is extremely difficult. One place investors scour is for lists of low PE stocks that they believe offer attractive value because they are “cheap.” The premise is often that if a stock is selling at a multiple at the low end of its 10-year PE range, it must be a real steal. Are “cheap” names really bargains? There are two reasons why I’ve never really thought this made much sense. First, when growth stocks are in their early stages of growth, they can grow earnings at double-digit rates. This includes technology and media companies like Microsoft, Apple, and Alphabet, as well as consumer products companies like Nike and Lululemon. During their hypergrowth, these companies can command PE ratios of more than 50 times their current earnings. As they age, the multiple typically declines, reflecting lower expectations for their net income. Second – and conversely – cyclical stocks may sell at their lowest PE when their earnings are at their highest. At that point, their earnings may be about to decline, which often coincides with underperformance. However, my thesis is purely speculative. It’s time to dig into the data and test my assumptions. The ‘cheap’ names don’t always outperform. We looked at the 100 largest stocks in the S&P 500 for five consecutive years, using their PEs based on current-year earnings, excluding stocks whose PEs were 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 its history. A ratio of 2 means the stock is trading today at double its 10-year average PE, and a ratio above 0.5 would indicate a PE that is half its historical multiple. We then grouped these stocks into quintiles based on their relative PE ratios from highest (quintile 1) to lowest (quintile 5). We used the years 2015 to 2019 to gather a broad dataset, understanding that the 2019 cohort would be impacted by the pandemic. To determine whether a low relative PE correlates with subsequent outperformance, we calculated the average compounded return for each quintile over the subsequent four years. 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 show that, despite their historically low PE ratios, the lowest quartile of stocks performed the worst in three of the five years under review. The best-performing quartile was the third quartile, perhaps because these names are maintaining their growth trajectory. These stocks may not be overvalued at current valuations and show no clear signs of earnings decline. This evidence seems to refute the notion that relatively low PE names are fertile ground for attractively priced stocks, at least in the years under review and for the top 100 names in the S&P 500. It never hurts to test a theory that might be flawed. We might learn something new that challenges conventional wisdom. Karen Firestone is executive chairman and co-founder of Aureus Asset Management, an investment firm that provides cutting-edge wealth management services to families, individuals, and institutions.
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The investment world loves benchmarks to measure, compare, and even hold sacred. One of the most sacred is price-to-earnings ratiois defined as the stock price divided by net income per share.
The higher the PE ratio, the more investors believe the business will generate strong earnings growth in the future to justify today’s price.
