Karen Firestone: Cheap stocks are appealing – but not always the best deal. Here’s why

The investment world loves goalposts to measure, compare, and even hold sacred. One of the most holy is the price-to-earnings ratio , defined as a stock price divided by its net income per share. The higher the PE ratio, the more investors believe the business will generate strong earnings growth in the future to justify the price today. For example, if a company's stock price is $30 with earnings per share (EPS) of $1.00, it has a current price-to-earnings multiple of 30. If EPS growth is expected to be 50% next year and 40% the following year, the stock sells at only 14.3 times earnings two years in the future. The market is willing to pay a premium for future net income growth. On the other hand, a stock now selling at $30, with EPS this year of $1.50, has a PE of 20. With only 5% earnings growth expected per year, its two years' forward PE would be 17.6 times. Even with 50% more earnings now, the market prices it equally to the prior example with the higher growth rate. The S & P 500 now trades at an all-time high multiple of 22.6 times estimated 2024 earnings and 21.1 times 2025 earnings. Even excluding the technology sector, which trades at a robust 30.8 times earnings, the market's PE is a solid 18.3 times next year's earnings, according to FactSet. At these levels, the hunt for attractive, undervalued names is extremely challenging. One place investors scour is the list of low PE stocks, which they perceive as offering attractive value because they are "cheap." Often the premise is that if a stock sells at a multiple at the low end of its 10-year PE range, it must be a real steal. Are 'cheap' names really a good deal? There are two reasons why I never really thought this made any great sense. First, when growth stocks are in their early stage of expansion, they can grow earnings in the high double-digits range. This includes technology and communications companies such as Microsoft , Apple , and Alphabet , but also consumer products businesses like Nike and Lululemon . During their hypergrowth, these companies can command PE ratios well over 50 times their current profits. As they age, the multiple often recedes, reflecting lower expectations for net income gains. Second – and at the opposite end – cyclical stocks may sell for their lowest PE when their earnings are at a peak. At that point, their earnings may be about to decline, which often coincides with stock underperformance. However, my thesis was purely conjecture. It was time to dig into the data and test my assumptions. 'Cheap' names don't always see outperformance We reviewed statistics on the 100 largest stocks in the S & P 500 for five consecutive years, using their PE on current-year earnings, excluding stocks whose PE was unavailable because of losses. We compared each stock's year-end PE to its 10-year average to give us a ratio showing how its valuation now compares to its history. A ratio of 2 would mean the stock trades today at twice its 10-year average PE, and one of 0.5 would signify a PE half its historic multiple. Then, we grouped these equities into quintiles based on their relative PE ratio from highest (1 st quintile) to lowest (5 th quintile). We used the years 2015 through 2019 to gather a data set of some breadth, understanding that the 2019 cohort would be affected by the pandemic. To determine whether a low relative PE correlates with subsequent outperformance, we calculated the average compound rate of return for each quintile for the following four years. Then we ranked these quintile returns by year from highest (1) to lowest (5). The data is in the table below. The data indicate that, despite being at PE levels low relative to their history, the lowest cohort of stocks performs the worst over three of the five years observed. The top-performing quintile is the third, perhaps because the names are maintaining their growth trajectory. These stocks might not be overpriced at current valuations and are not showing obvious signs of earnings declines. This evidence appears to refute the notion that names with low relative PE are a fertile breeding ground for attractively priced stocks, at least for the years observed and for the top 100 names in the S & P 500. It never hurts to test a theory that might be flawed. We might learn something new that challenges conventional thinking Karen Firestone is executive chairman and co-founder of Aureus Asset Management, an investment firm dedicated to providing contemporary asset management to families, individuals and institutions.

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The investment world loves goalposts to measure, compare, and even hold sacred. One of the most holy is the price-to-earnings ratio, defined as a stock price divided by its net income per share.

The higher the PE ratio, the more investors believe the business will generate strong earnings growth in the future to justify the price today.