Does PE Ratio Matter?

Introduction - Is P/E Ratio Important?

According to the data compiled by Nobel Prize laureate Eugene Fama and Dartmouth professor Kenneth French, over rolling 15-year time periods from 1927 through 2019 value stocks have outperformed growth stocks 93 percent of the time. Does this mean that buying stocks with lower PE Ratio is a superior strategy? Not necessarily as there are valid reasons for high versus low pe ratio, and this strategy would have missed companies like Facebook (ticker: FB) and Amazon (ticker: AMZN). On the other hand, it also would have missed numerous growth stocks that flopped and could not retain their rich valuations. Let’s do our own data experiment on the S&P 500 index and see what we can find. The data we use goes back to 1871.

Trailing PE Ratio v 1-Yr Annualized Return

Current Data versus Future Performance

Trailing PE Ratio v 3-Yr Annualized Return

Current Data versus Future Performance

Trailing PE Ratio v 5-Yr Annualized Return

Current Data versus Future Performance

P/E Ratio is Somewhat Predictive

The graphs above show a negative correlation between current trailing PE Ratios and the future 1-year, 3-year, and 5-year stock market returns. In other words, if you invest in the S&P 500 when trailing PE Ratio is high you will likely return less than if you invested when trailing PE Ratio is low. Therefore, we agree with the conclusions presented in the introduction. One word of caution, there is extreme variability in the data. In other words, shorting the market during high trailing PE Ratios is not a guarantee as these high trailing PE Ratios can persist.

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