The Investment Scientist

Posts Tagged ‘stock valuation

Warren Buffet said: “Price is what you pay and value is what you get.”

Wall Street uses the price-to-earning ratio, or the P/E ratio in short, to determine whether one gets what one pays for when buying a stock. Is this ratio just a myth? Or is it a useful valuation measure?

To answer this question, I examined the whole stock market data for the past 50 years from 1958 to 2007. For each year, I separated stocks into three portfolios: the top 30% P/E portfolio, the middle 40% P/E portfolio and the bottom 30% P/E portfolio. (Stocks with negative earnings are all in the top 30% P/E portfolio.)

If I had invested $1 in each of the three portfolios at the beginning of 1958, by the end of 2007, the top 30% P/E portfolio would have grown to $91; the middle 40% P/E portfolio would have grown to $322 and the bottom 30% P/E portfolio would have grown to $1698! (The chart below shows the growth of $1 in the three different portfolios in logarithmic scale.)

PE ratio and stock returns

In fact, in the past 5 decades, there was not a single decade in which the bottom 30% P/E portfolio did not outperformed the top 30% P/E portfolio. The decade spanning 1968 to 1977 was especially eventful: two global recessions, the Arab-Israeli war and the Arab oil embargo. The returns of the three portfolios in that decade are as follows:

Top 30% P/E portfolio: 31%

Middle 40% P/E portfolio: 61%

Bottom 30% P/E portfolio: 137%

It is safe to conclude that the P/E ratio is a very useful valuation measure for long-term stock investment. The lower the P/E ratio, the higher is the expected long-term return. That does not mean that low P/E stocks outperform every year though. In the last 50 years, there are 12 years in which the top 30% P/E portfolio outperformed the bottom 30% P/E portfolio. Take 2007 for example, the top 30% P/E portfolio outperformed the bottom 30% portfolio by more than 13%.

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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