The Price-to-earnings (P/E ratio) is a valuation ratio of a company's current share price compared to its per-share earnings. The P/E is sometimes referred to as the "multiple", because it shows how much investors are willing to pay per Rand of earnings. Made popular by the late Benjamin Graham, who was dubbed the "Father of Value Investing" as well as Warren Buffet's mentor, Graham preached the virtues of this financial ratio as one of the quickest and easiest ways to determine if a stock is trading on an investment or speculative basis. A low PE indicates value and conversely a high PE indicates "expensive".
Another great investor, Martin Zweig commented : "The data going all the way back to the 1930s show conclusively that stocks with low price/earnings ratios outperform stocks with high price/earnings ratios over the longer term". Zweig's view was that although stocks with high PE's have been known to perform well, when these stocks miss forecasted earnings they get punished much worse than lower PE stocks and thus he would avoid them altogether. However Zweig also avoided stocks with "too low" PE's as he considered that something must be fundamentally wrong for these stocks to warrant such PE's.
Of course, a low PE may indicate a "cheap" share but it will not necessarily indicate a "good quality" or "value" share. Generally speaking, PE ratios of stocks need to be compared to those of stocks in similar industries, however for the purposes of the PowerStocks PE study, we will be simply seeking to correlate the growth of all shares related to their PE's.
The graph below shows the growth achieved by JSE stocks since the trough of the last big JSE bear market, relative to their 1-year trailing PE's as at 28 April 2003. Note that only 136 stocks that averaged more than 3 trades a day during the month of April 2003 were considered (98 stocks were considered not liquid enough)
Sure enough we find a strong correlation between PE and share price growth. More significantly, those stocks with PE's between 2-4 significantly outperformed the ALSI (All share Index) as well as all the other PE groupings. True to Zweig's affirmations, those PE's that were "very low" significantly underperformed the market.
There were 11 stocks with PE ranging from 2 to 4 and 28 stocks ranging from PE of 4 to 6, making altogether 39 stocks with a PE between 2 and 6 which averaged 508% growth. As a general observation we can safely state that historically, stocks with PE's between 2 and 6 outperformed all other stocks in the last JSE crash. (This is very close to what we saw in the 8-year backtest)
If you would like to see a longer term 8 year test on PE covering a wider range of boom and bust cycles then go to the RESEARCH section and GO BACKTESTS.
RELATED --> | See comprehensive 8 year backtest on JSE |See ALSH Index PE & growth tests |