Do stocks with low price-earnings ratios outperform stocks with high price-earnings ratios? Some tests indicate that low P/E stocks do offer excess returns. Critics of these tests, however, contend that the higher observed returns are attributable, not to the P/E ratios, but to the small firm size and infrequent trading that tend to characterize low P/E stocks.
The authors control for the small firm and infrequent trading effects by including in their tests only frequently traded stocks of companies of a certain size. In addition, they control for another possible bias—the industry effect. Because firms in the same industry tend to cluster in the same relative P/E ranking, detected return differences between P/E groups may be attributable to industry performance, rather than P/E level. This bias is eliminated by using price-earnings relatives (PERs)—the index of the P/E ratio of a stock relative to its industry.
The results indicate that PER is a significant factor related to excess returns. Low PER portfolios tend to outperform high PER portfolios, as well as the sample mean. Furthermore, as PER increases, returns decline consistently.