Would you like to move to a new improved price-earnings ratio (P/E) that will give you an edge over other investors? These pages tell you how. They are the result of the latest academic research that has not yet come into mainstream use by investment managers. What you will read on these pages summarises three years' work for my PhD and three published academic papers.
Many investors know and use the P/E daily as one of the main descriptors of a company's attractiveness at its current price. What they may not appreciate is that the P/E is next to useless at predicting returns!
Typically, researchers find that portfolios of low P/E shares outperform the market by 3-4% per year on average, and high P/E portfolios underperform it by the same amount. This isn't a lot compared to the overall movements of the market. Make a few unnecessary small-cap trades and you could easily lose more than that in the bid-ask spread. After three years of researching the P/E, the wonder to me is that anyone pays any attention at all to it!
However, this doesn't mean that the P/E can't be turned into something useful. A few simple* calculations can give you a P/E statistic that is two or three times as useful at predicting returns. Those who are prepared to take on more risk in a concentrated portfolio would have earned returns approaching 40% per year since 1975...
These web pages highlight the result of academic research and are presented free of charge to stimulate debate. They should not be taken as investment advice or invitations to buy or sell securities, and the author accepts no responsibility for any losses, financial or otherwise, that may be purported to have arisen from actions taken on the basis of their contents.
* The idea behind it is simple. To actually do it yourself as I did, you need access to Datastream, several months spare to calculate the P/Es for all UK companies annually since 1975, form portfolios and calculate the returns, and at least MSc level econometrics to analyse the results.
Copyright Dr. Keith Anderson 2010
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