Behavioral finance FAQ / Glossary (P/E)

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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!

Why low P/E make salivate?

It seems investors interpret a low P/E as an underpricing, as if

current earnings were the best indicators of what a business
is worth.

After a lackluster performance, those stocks benefit often (albeit
not always), from a surge of investor preference.

A buying stream bolsters their price (and ths their P/E) 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 skew / anomaly
in the "efficient" valuation that is supposed to drive
asset market prices.

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 not be based on today "earnings return"
but on future earnings and future risk projections, .

The fact that stocks with low trailing P/Es offer (usually) better returns might
shows thus

* either an exploitable anomaly
* or a common confusion between the present and the future.
  Time warp?

Such a behavioral bias, based on a simplified valuation approach
(see heuristic), might distort the stock price formation, unless of course
other criteria
, 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 that earnings are temporarily

depressed, or that their low level precedes a probable sizable
earnings growth.

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 an ungrounded 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 either
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 investor attention and fashion being elsewhere.

Stocks suffering from previous excesses of pessimism on 

their prospects (negative overreaction),

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, lack 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 strlng past growth, it does not mean
that this growth is sustainable
in the future.

Alternative indicators

Pouring price, earnings and past or future growth
into 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 to their pockets.

But things are much less clear-cut: see "dividend puzzle".

(*) To find those messages: reach that BF group and, once there,
      1) click "messages", 2) enter your query in "search archives".

Members of the BF Group, please
 vote on the glossary quality at BF polls

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This page last update: 05/09/15  

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