Is the price-to-earnings (PE) ratio a good predictor of future stock-market returns? The PE ratio is a common valuation tool to measure how expensive a stock is. It is simply the price of a stock divided by its earnings per share.
The easy way to look at the PE is to invert the formula and think in terms of yield. For example, a PE of 10 is equivalent to a 10 percent earnings yield and a PE of 20 is equivalent to 5 percent.
This compares to a 10 year bond yield of 10 percent. Based on our analysis of PE and returns for the last 18 years, we found there to be no correlation between the PE of the market and investment returns. The correlation between the returns and its PE is -30 percent, which also means that only 9 percent of the movement in the stock-market can be explained by the PE ratio.
Normally investors associate a high PE market with high risk. However, looking back at the last four major market declines (which we define as negative returns of more than 20 percent) there were 2 years when the market PE (median) was relatively low, at 10.1 and 8.1. This compares to the historical average PE of 10.6. For the other two major declines, the PE was relatively high at 14.6 and 20.8.
We calculated our PE by taking all the PEs for listed stocks at the end of the year using trailing earnings and excluded those that had very low and negative earnings. Then we took the median PE of these listed stocks. We compared the PE with the one year forward return of the Jakarta Composite Index (JCI).
On the flip side, there were six years where returns were above 50 percent. These were equally split between high and low PEs. Hence investors should not fear the high PE years any more than low ones.
So how does an investor use the PE ratio to make investment decisions? The PE of the markets should not be used to determine your investment decision
However, once you have decided to invest in the market, the PE ratio is useful. We have found a consistent pattern of low PE stocks outperforming higher PE stocks. We define low PE as stocks that have a PE lower than the median PE of all the listed stocks.
Low PE stocks have outperformed high PE stocks by 41 percent on average for the past 18 years. Low PE stocks also tend to outperform the market.
In the past 18 years, low PE stocks outperformed the JCI in 14 years or 78 percent of the time. Its average outperformance against the JCI was 29 percent.
In contrast, high PE stocks underperformed the market in 15 years (or 83 percent) with an average underperform of 11 percent.
So why do low PE stocks tend to outperform high PE stocks and the market in general?
It is our view that low PE stocks are generally undiscovered and have fewer analysts following them. Once these companies are discovered, then prices may reflect their greater popularity.
Also, low PE stocks tend to be smaller in size and hence require a greater return.
Smaller companies tend to grow faster and have potential higher returns. You can also have large companies that are out of favor which may result in a low PE. These situations could provide greater relative returns for low PE companies.
So, a low PE strategy is a good starting point to improve your chances of obtaining relatively better investment returns.
The writer is the portfolio manager at Manulife Aset Manajemen Indonesia
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