Does PE Ratio Matter?

There are two kinds of PE ratios that are typically calculated, absolute PE ratios and relative PE ratios. Absolute PE ratios are essentially a stock’s current price divided by its most recent 12 months of earnings. Relative PE ratios tend to compare a stock’s absolute PE ratio to an industry average or to a stock’s own average PE over some past period. So, getting back to the question of does PE ratio really matter, it does especially if selecting stocks from a quality database like the S&P 500. A subset of stocks selected from the S&P 500 with the lowest PE ratios has outperformed the S&P 500 rather handily over the last 21 years.

Based on our research, a portfolio consisting of 15 S&P 500 stocks with the lowest absolute PE ratios would have returned 3.8% more than the S&P 500 over the 21-year period ending on 12/31/2021. On the other hand, a portfolio of 15 stocks with the highest PE ratios would have outperformed the S&P 500 by only 1.1% over the same 21-year period. For further perspective, a 50-stock portfolio with the lowest absolute PE ratios would have returned 2.1% more than the S&P 500 whereas, a 50-stock portfolio of the highest PE ratios from the S&P 500 would have underperformed by -0.9% over the same time frame. So, for S&P 500 member stocks, absolute PE has definitely mattered over the most recent 21-year period ending on 12/31/2021.

Comparably, our Investoristics 10 approach which relies exclusively on relative PE ratios would have more than doubled the performance of the 15-stock low PE portfolio over the same 21-year period. A portfolio selected today using our Investoristics 10 strategy would have an average PE of just over 14 while the 15-stock portfolio consisting of the lowest PE ratios from the S&P 500 would have an average PE ratio of about 5.5. In this case, our flagship portfolio more than doubled the performance of the portfolio with the lower average PE ratio. Again, PE ratios do matter however, it also depends on the other fundamental characteristics emphasized in the construction of your portfolio.

Clearly, Investors who have a long-term perspective could benefit from holding a basket of securities that have lower absolute PE ratios. The investor choosing this approach would have to be willing to rebalance the portfolio annually as well as choosing the desired number of stocks to hold in the portfolio. In all cases for the 21-year period studied, our research consistently shows that holding fewer stocks is better than holding more than 50 stocks when employing a low PE approach or variation thereof.

At Investoristics we chose a relative PE vs absolute PE approach to build our winning portfolio.  Keep in mind however, that using relative PE can be more challenging as it requires more discretion when interpreting the relative PE ratios. Here at Investoristics, we rely exclusively on the use of relative PE ratios and combine them with other fundamental data that are indicative of future outperformance vs the S&P 500. But in the end, relatively lower PE ratios bode well for our approach. Interested in knowing more or want to join “The Collective?” Feel free to contact us at any time.