LOW P/ES MEAN LOW RISK
People tend to think low price-to-earnings (PIE) ratios mean low risk for single stocks and the market as a whole. It’s an almost universal, near-religious belief that “everyone knows.” But it’s just wrong. Using P/Es to forecast risk and return over any reasonable time period is about as useful as using a Ouija board.
I debunked the “high P/Es are risky, low P/Es aren’t” myth pretty thoroughly in my 2006 book, The Only Three Questions That Count. Taking it apart multiple ways took up about half a big chapter. I won’t restate that here, but instead take you through yet another way to know P/Es—high or low—aren’t predictive on their own. (I also co-authored a scholarly piece on why P/Es don’t forecast risk or return with my buddy Meir Statman that you can find on the Internet if you’re academically oriented—“Cognitive Biases in Market Forecasts,” Journal of Portfolio Management, Fall 2000.)
My criticism here doesn’t mean P/Es aren’t useful. They can be—but not as forward-looking predictors of market or stock returns. Like all commonly used valuations, their predictive power is long gone since anyone can get them lightning fast on the Internet and markets pretty efficiently discount all widely known information. Use them to compare stock peers, sure. Flip the P/E over into an E/P (the earnings yield) and compare that as a form of an interest rate to going bond yields to know if a firm or sector or the entire market has more incentive to issue new shares ...