One of the more familiar metrics for stock analysis is the Price-to-Earnings (P/E) ratio. A simple ratio, it takes the price of a stock, and divides that by its earnings per share. For example, a stock with a P/E ratio of 15 would indicate that the company is selling for $15 for every one dollar of earnings. Common belief is the lower the P/E ratio is, the cheaper it is. Benjamin Graham famously wrote that one should find companies with a P/E ratio lower than 15.
In continuing to find efficient screening techniques so one can find profitable investments, we conducted a simple experiment to find which P/E ratios would help one beat the market.
Again, we analyzed companies that are valued at more than $5 per share. We also analyzed the returns of companies based on their P/E ratios. We grouped companies based on their ratios, in intervals of five. We used Value Line data from 1986 to present for the analysis.
The results are not very surprising. The effective range for P/E ratio is between five and 45. All of the intervals outperformed the S&P 500 return of 10.272% for the same period. Interestingly, one can buy too cheap. Stocks that have a P/E between zero and five had a negative average annual return. This is not too surprising, given that Martin Zweig wrote in his book, Winning on Wall Street, to stay away from this discount aisle.
If we add the P/E metric to our building screen, we have now narrowed our stock opportunities to 1,871 issues, and the five largest, based on market cap, are Apple (AAPL), Exxon Mobil (XOM), Microsoft (MSFT), General Electric (GE), and Johnson & Johnson (JNJ). These stocks are a definite good start for a profitable portfolio.