The price-to-earnings (P/E) ratio is a remarkably indicative fundamental ratio of future performance, yet it is often ignored or dismissed. As an employee or retiree from Fortune 500, understanding the P/E ratio becomes of great benefit when evaluating potential assets to invest in. Currently, the S&P 500 is at a P/E ratio of 40.13, well above its longtime average of 15.91. The P/E ratio is a valuation ratio for a company that measures its current share price relative to its earnings-per-share (EPS). The P/E ratio can be calculated as Market Value-per-Share/Earnings-per-Share. The P/E ratio indicates the price an investor is willing to pay for each dollar of net earnings for the company. For instance, if a company had a share price of $20 and its EPS is $2 then the P/E ratio is 10. A stock that trades at a low P/E is generally considered “cheap”, while a stock with a high P/E indicates a more expensive stock as investors might expect more growth.
With a volatile market, it is understandable to wonder how the market is going to perform moving forward. When comparing historical P/E ratios with the short-term future performance it is still apparent that “cheaper” stocks outperform (shown to the right). In addition to higher average performance, it was found that (when looking out one year) the market was higher 77% of the time if the P/E ratio was below 13.2 as compared to 58% of the time when the P/E ratio was over 19.1. As an employee at Fortune 500, it becomes imperative to understand these metrics and utilize them to your advantage in order to make the most of your unallocated assets.
As an employee or retiree at Fortune 500, you understand the value of data-driven research. In a study by Quantitative Alpha, they analyzed the performance of the 1000 largest global companies (by market cap) by sorting them into quintiles based on price-to-earnings ratios. Stocks with negative earnings were excluded. They examined the returns of the five equal portfolios consisting of 200 stocks each over a twenty-one-year period, from December 31, 1995, to December 31, 2016, with the portfolios rebalanced quarterly. Their results are shown in the charts below and on the next page.
In their study, they found that the quintile of the lowest P/E stocks significantly outperformed the high P/E quintile. Fortune 500 employees or retirees, this information is very valuable as it may help you increase your gains. The analysis conducted demonstrated that the portfolio containing the lowest P/E stock returned 11.61% annualized compared to 4.83% for the highest P/E portfolio and 7.55% for the used universe of stocks. The graph below shows how the cumulative returns compare (it’s not even close).
In a study over a longer time period, screening for low P/E stocks has been shown to have less downside risk than high P/E stocks. By understanding this relationship, Fortune 500 employees or retirees become unlikely to partake in risky market moves, and instead synthesize a portfolio with lessened volatility and increased returns. In a backtest from 1979 to 2015 (shown in the chart below), it was found that attractive valuations were followed by lower price declines than high valuations. For every valuation metric under consideration, the chart shows the maximum losses investors could have suffered if they had sold at the worst point in time following a certain valuation level. Under these circumstances, the downside risk increases with rising valuation levels. Fortune 500 employees, it is of utmost importance to consider the valuation level in order to avoid investing in an asset with a further downside that could result in financial loss.
