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Crunching the Numbers

Earlier in this chapter, reference was made to a rule of thumb that a stock that trades at a PE ratio less than 8 is cheap. While there are numerous benchmarks such as these in the market, you should be wary of these numbers. Many of them are outdated and have no basis in fact. In this section, you will begin by looking at the distribution of PE ratios across the market to get a sense of what would constitute a high, low or average PE ratio. You will then follow up by looking at how PE ratios vary across different sectors and also how they have changed over time. Finally, you will construct a portfolio of stocks with the lowest PE ratios in the market, with the intention of examining it more closely for potential flaws in the strategy.

PE Ratios Across the Market

While there are numerous rules of thumb when it comes to PE ratios, it is impossible to assess whether they make sense without looking at how PE ratios vary across stocks in the market. Figure 3.4 presents the distribution of PE ratios for all U.S. stocks in October 2002. The current PE, trailing PE and forward PE ratios are all presented in this figure.

Figure 3.4. PE Ratios Across the Market: October 2002

Data from Value Line. The number of firms in the United States that fall within each PE ratio class for stocks is reported.

Looking at this distribution, you can see that while there are a large number of companies with PE ratios between 8 and 20, there are also a significant number of companies with PE ratios well in excess of 100. Some of these companies are high growth companies that trade at high prices relative to current earnings because investors expect their earnings to grow substantially in the future. Some of these companies are cyclical companies whose earnings have dropped as a consequence of a recession. Since investors expect their earnings to bounce back as the economy recovers, the price-earnings ratio is high. At the other extreme are companies whose PE ratios are 12 or less. In October 2002, these firms would be considered cheap if you looked at just the PE ratio. A final point about these PE ratios relates to companies for which the PE ratio could not be computed because earnings per share were negative. In the sample, which included 7102 companies, 3489 companies had negative earnings in the most recent financial year and current PE ratios could not be computed for them. With trailing and forward earnings, you continue to lose about 40% of the overall sample for the same reason.

The fact that PE ratios cannot be less than zero but can take on very high values has consequences when you compute statistics. The average PE ratio, which is computed by averaging across all companies, will be pushed up by the extreme high values. A far more meaningful statistic would be the median PE; half of all companies will have PE ratios less than this value, and half of all companies will have PE ratios that are higher than this value. Table 3.1 summarizes statistics on both measures of the price-earnings ratio, starting with the mean and the standard deviation and including the median, 10th and 90th percentile values.

Table 3.1. Summary Statistics: PE Ratios for U.S. Stocks
90th percentile69.0253.7436.86
10th percentile4.225.697.94

Looking at all three measures of the PE ratio, you see that the average is consistently higher than the median, reflecting the fact that PE ratios can be very high numbers but cannot be less than zero. It is not surprising that analysts wishing to sell you stocks often use the pitch that the PE ratio for the stock is below the average for the industry. An effective retort would be to ask them whether the PE ratio for the stock is less than the median for the industry.

PE Ratios Across Sectors

Price-earnings ratio can vary widely across sectors, and what comprises a low PE ratio in one sector can be a high PE ratio in another. In Table 3.2, the ten sectors with the lowest and the highest average PE ratios (current) in the United States in October 2002 are listed.

Table 3.2. Highest and Lowest PE Ratio Sectors
Steel (Integrated)7.98Entertainment41.43
Homebuilding9.46Telecom. Services43.14
Electric Utility10.18Precision Instrument44.17
Auto Parts10.75Semiconductor47.10
Insurance (Life)10.90E-Commerce50.32
Apparel11.18Cable TV53.49
Home Appliance11.70Wireless Networking60.49
Thrift11.97Chemical (Basic)60.76

What are the reasons for the vast divergences in PE ratios across sectors? The fundamentals that were outlined earlier as the determinants of PE—growth, risk and payout (return on equity)—provide the explanation. In general, the sectors with the lowest PE ratios offer not only the lowest expected growth but also have low returns on equity. The sectors with the highest PE ratios offer higher expected growth and higher returns on equity, albeit with more risk. Table 3.3 contrasts measures of growth, risk and return on equity for the two groups: the ten sectors with the highest PE ratios and the ten with the lowest.

In estimating return on capital and return on equity, the averages over the last five years were used to overcome the depressed earnings (and returns on equity) caused by the recession in 2002. Note that the lowest PE sectors have lower projected growth in earnings and revenues and lower project returns than those in the highest PE sectors.

Table 3.3. Comparisons on Fundamentals: High PE vs. Low PE Sectors
Low PE sectors0.610.48 11.61%5.56% 7.64%9.30%
High PE sectors1.760.84 17.01%7.65% 14.66%16.50%

[a] ROIC: Return on invested capital; ROE = Return on equity.

PE Ratio Across Time

A PE ratio of 12 can be considered low in today's market but it would have been high in the equity market of 1981. As PE ratios change over time, the criteria for what constitutes a low or a high PE will also change. Consequently, the average PE ratio for all stocks in the United States is examined in Figure 3.5.

Figure 3.5. PE Ratio for S&P: 1960–2001

Data from Bloomberg. This is the average PE ratio across all U.S. stocks at the end of each year from 1960 to 2002.

Note that the PE ratios have varied significantly over time, reaching a low of about 7 in 1975 and climbing to a high of 33 at the market peak in 1999.

What causes PE ratios to change over time? The very same factors that determine the PE ratios of individual companies—cash flows, growth and cost of equity—also determine the PE ratios for individual companies. PE ratios were low in the mid-1970s because economic growth was dragged down by the oil embargo and subsequent inflation in the United States and because nominal interest rates were high. In fact, the period between 1975 and 1981 when PE ratios remained low represents a period when government bond rates in the United States reach double digits for the first time in history. The decline in interest rates in the 1990s accompanied by rapid economic growth and higher productivity in the 1990s contributed to making PE ratios in that decade much higher.

As PE ratios change over time, the determination of what constitutes a low PE will also change. In Figure 3.6, you examine the PE ratios that would have represented the 5th, 10th and 25th percentile of all stocks listed on the New York Stock Exchange every year from 1951 to 2001.

Figure 3.6. PE Ratio: Cutoffs over Time

Data from Fama/French. The 5th, 10th, and 25th percentile of PE ratios across all U.S. stocks is reported for each year.

In 1975, the low point for PE ratios for U.S. stocks, 5% of all stocks had PE ratios less than 2.18, 10% of all stocks had PE ratios less than 2.64, and 25% of all stocks had PE ratios less than 3.56. In contrast, in 1998, 5% of stocks had PE ratios less than 9.42, 10% had PE ratios less than 11.64, and 25% had PE ratios less than 14.88. This is why a rule of thumb (e.g., PE less than 8 is cheap!) has to be taken with a grain of salt. While it would have been factual in 1998, it would not have been so in 1975, since more than half of all stocks traded at PE ratios lower than 8 in that year.

A Low PE Portfolio

If you decided to adopt a strategy of buying low PE stocks, what would your portfolio look like? The only way to answer this question is to create such a portfolio. Assume you begin with the all listed U.S. stocks and screen for the stocks with the lowest PE ratios. You have three measures of the PE ratio for each company: the PE based upon earnings in the most recent financial year (current PE), the PE based upon earnings in the most recent four quarters (trailing PE), and the PE based upon expected earnings in the next financial year (forward PE). Each measure has its adherents, and there is information in each. Erring on the side of conservatism, you can look for stocks that have PE ratios less than 10 on all three measures. The resulting portfolio in October 2002 is presented in Table 3.4.

Taking a closer look at the portfolio, you will see that 116 stocks in the market (out of an overall sample of 7000+ companies) met the criteria of having current, trailing and forward price earnings ratios all less than 10. The portfolio is fairly diversified, though utility and financial service stocks are disproportionately represented.

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