Behavioral finance FAQ / Glossary (P/E)
This is a separate page of the P-Q section of the Glossary
Dates of related message(s) in the
Behavioral-Finance group (*):
Year/month, d: developed / discussed, i: incidental
P/E (PER) effect
03/12i + see PBR effect, value stock
Stocks that look low-priced tend to see their price rise
as if they were low-priced.
Which maybe they were, after all?
Don't panic, after reading it three times using a strong torchlight,
the obscurity might subside somewhat ;-)
Definition: The PE effect / P/E effect is a market price distortion
in which stocks with a low P/E (*) tend later to outperform the market.
(*) aka PE ratio, or PER price / earnings ratio.
Caution: that paradigm often works, but like all paradigms, not always!
It seems that investors interpret a low P/E as an underpricing,
as if current earnings were the best indicators of what a business is worth.
Those stocks benefit often (albeit not always), after a lackluster performance,
from a surge of investor preference. A buying stream bolsters their price
(and their P/E in their turn) and contribute to give them, in average,
better risk-adjusted returns than other stocks.
Real adaptation to real value, or self fulfilling prophecy?
An effect among others
Like the PBR effect, the size effect and the calendar effect
(see effect), this phenomenon is often considered, in academic
bars, as just a mild anecdotal market skew / anomaly
in the "efficient" valuation.
That is why the Arbitrage Pricing Theory (see that phrase) categorizes it,
with those other market effects, as an arbitrage opportunity factor.
Is it an investor bias?
Mental time confusion between past, present and future?
Investing decisions should normally be based instead on future earnings and
future risk projections, not on today "earnings return".
The fact that stocks with low trailing P/Es offer (usually) better returns might show
therefore a widespread confusion between the present and the future. Time warp?
Such a behavioral bias, as a simplified valuation approach (see heuristic), might
distort the stock price formation, unless of course other criterion, that investors did not
notice previously, warrants those stocks' "cheapness".
And what about high PE ratios?
Beware, anyway: the same that a low trailing P/E doesn't make certain that a stock
is cheap, a huge trailing P/E is not always a sign that it is expensive.
Again, things depends of future earnings more than on current ones.
=> A high PE might reflect for example the fact that earnings are temporarily
depressed, or that their low level precedes a probable spectacular earnings
Or not really a bias?
A signal of value?
A bargain not to miss?
At first glance, it seems wrong to use the P/E on current earnings as a key indicator
to judge if a stock is cheap or expensive.
But it actually could allow to take advantage of that bias (albeit without certainty
about the outcome), as it can signal a market disdain towards the related stocks, or
an excessive exuberance for other ones.
Maybe the bias is sometimes only apparent, or at least, when it is real, not always damaging.
The role of the P/E level in investment decisions brings a crucial
element in the famous debate on choosing value stocks or growth
stocks (see those phrases).
Studies have shown that stocks with low trailing P/E, low P/B, low price /
sales ratio, tend to outperform the market
That might explain why stocks with such traits are often called "value stocks"
(see that phrase).
If, often also, they prove to be good buying opportunities, it may be
that their low ratios are typical signals of:
Stocks which the market is not interested in at the moment, the
attention and fashion being elsewhere.
Stocks suffering from previous excesses of pessimism on their
prospects (negative overreaction),
And businesses that have the potential to recover (underreaction).
This has to be handled with care, as some declining stocks that
muddle through with residual earnings, do not have the fundamentals
allowing for a recovery potential, except for some temporary rebounds.
Cheapness might not be what all P/E watchers are looking for.
Those who look for growth stock often consider that a high P/E is a rough
indicator of future high growth.
This is not completely fool-proof either, if the PE is usually high for
stocks with high past growth, it does not mean that this growth is
sustainable in the future.
Pouring price, earnings and past or future growth in the shaker
to mix the stock value cocktail.
Sometimes the PE is combined with other criteria to make a composite ratio.
This is the case of the PEG. It is the quotient between:
* the PE
* and the annual percentage of previous earnings growth.
A very rough indicator also. The lower the PEG, the more tasty would the stock be.
Normally what would be more relevant than the trailing P/E is:
The prospective P/E, in other words the P/E based on expected earnings
several years ahead.
Or better, a mathematical financial actualization of the prospective P/E,
what can be called the primary P/E.
Or another relevant notion, the dividend yield (dividend / price ratio).
Theoretically shareholders should give it more importance to that yield than to
the P/E, as dividends are what the company delivers in their pocket.
But things are much less clear-cut: see "dividend puzzle".
(*) To find those messages: reach that Behavioral-Finance group and, once there,
1) click "messages", 2) enter your query in "search archives".
Members of the Behavioral Finance Group, please vote
on the glossary quality at Behavioral-Finance/polls