Investing Using the Price-to-Earnings Ratio and Earnings Yield (Backtests 1951 to 2013)

Investing Using the Price-to-Earnings Ratio and Earnings Yield (Backtests 1951 to 2013)

By greenbackd

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The humble price-to-earnings (PE) ratio is a remarkably well-performed fundamental ratio. While I generally favor the enterprise multiple when demonstrating the utility of focusing on intrinsic value and investing in undervalued stocks (for the reasons outlined here), I’d be very happy to run a portfolio if I was only able to use the PE ratio.

Set out below are the results of two Fama and French backtests of earnings yield (the inverse of the PE ratio) data from 1951 to 2013. As at December 2013, there were 2,406 firms in the sample. The value decile contained the 283 stocks with the highest earnings yield, and the glamour decile contained the 281 stocks with the lowest earnings yield. The average size of the glamour stocks is $4.4 billion and the value stocks $4.3 billion. (Note that the average is heavily skewed up by the biggest companies. For context, the 2,406th company has a market capitalization today of $300 million, which is much smaller than the average, but still investable for most investors). Stocks with negative earnings were excluded. Portfolios are formed on June 30 and rebalanced annually.

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Annual and Compound Returns (Portfolio Constituents Weighted by Market Capitalization)

In this backtest, the two portfolios weighted by market capitalization, which means that bigger firms contribute more to the performance of the portfolio, and smaller firms contribute less. Here we can see that the value decile has comprehensively outperformed the glamour decile, returning 16.7 percent compound (19 percent in the average year) over the full period versus 9.3 percent for the glamour decile (11.6 percent in the average year).

Average Earnings Yield (Market Capitalization Weight)

The reason for value’s outperformance is not very complicated. The value portfolios simply generated more earnings per dollar invested (19.1 percent versus 2.8 percent for the glamour portfolio):

Earnings Yield VW 1951 to 2013

Recent Performance (Market Capitalization Weight)

This is not a historical aberration. If we examine just the period since 1999, we find that, though the return is lower than the long term average, value continued to be the better bet.

VW PE Returns 1999 to 2013

Value has massively outperformed glamour since 1999, beating it by more than 10 percent compound, and 5.5 percent in the average year. The reason for lower returns recently may be due to the ubiquity of value strategies, but more likely it’s because the market is still working off the massive overvaluation in the late 1990s Dot Com boom.

Market capitalization-weighted returns are useful for demonstrating that the outperformance of value over glamour is not a function of the value portfolios containing smaller stocks. For most investors, market capitalization-weighted returns are irrelevant because we’re not going to invest portfolio capital according to a stock’s market cap. For one thing, it’s more difficult to manage and calculate on the fly than an equal weight portfolio, and it leads to lower returns. More likely, we’re either going to equal weight the portfolio (simply equally dividing the total portfolio capital over the total number of positions, say 10 to 30 stocks) or Kelly weight our best ideas. The equal weight returns are therefore more useful for most investors. For equal weight portfolios, the smallest stock is the most important one because the smallest stock constrains the portfolio capital, setting the maximum capital that can be invested in every other stock in the portfolio. (Recall that the smallest company in the sample has a market capitalization today of $300 million, which is investable for most investors.)

Annual and Compound Returns (Portfolio Constituents Equally Weighted)

PE EW Returns 1951 to 2013

In the equal weight backtest value generated 20.1 percent compound (23.3 percent on average), beating out glamour’s 9.8 percent compound return (13.3 percent on average).

Average Earnings Yield (Equal Weight)

Earnings Yield EW 1951 to 2013

Again, the value portfolios simply out-earned the glamour portfolios, generating 17.2 percent on average versus 2.7 percent in the glamour portfolios. It’s interesting to note that the average earnings yield for the equally weighed value portfolio is slightly lower than the average earnings yield for the market capitalization-weighted portfolios, which indicates that, over the full period, bigger stocks tended to be a cheaper method for buying earnings than smaller stocks. That won’t always be the case, but it’s interesting nonetheless.

Recent Performance (Equal Weight)

EW PE Returns 1999 to 2013

In the equal weight portfolios, value also outperformed glamour since 1999, beating it by 8.3 percent compound, and 7.1 percent in the average year.

Over the long run, cheap stocks tend to outperform more expensive stocks, and the PE ratio is useful metric for sorting cheap stocks from expensive stocks.

My firm, Eyquem, has just started offering low cost, fee-only managed accounts that implement a systematic deep value investment strategy. Please contact me by email at or call me by telephone on (646) 535 8629 to learn more.

Click here if you’d like to read more on Quantitative Value, or connect with me on LinkedIn.


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My name is Tobias Carlisle. I am the founder and managing member of Eyquem Investment Management LLC, and portfolio manager of Eyquem Fund LP. Eyquem Fund LP pursues a deep value, contrarian, Grahamite investment strategy based on the research featured in Quantitative Value: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors (hardcover, 288 pages, Wiley Finance, December 26, 2012), and discussed on Greenbackd. I have extensive experience in activist investment, company valuation, public company corporate governance, and mergers and acquisitions law. Prior to founding Eyquem, I was an analyst at an activist hedge fund, general counsel of a company listed on the Australian Stock Exchange, and a corporate advisory lawyer. As a lawyer specializing in mergers and acquisitions I have advised on transactions across a variety of industries in the United States, the United Kingdom, China, Australia, Singapore, Bermuda, Papua New Guinea, New Zealand, and Guam, ranging in value from $50 million to $2.5 billion. I am a graduate of the University of Queensland in Australia with degrees in law and business (management). Contact me I can be contacted at greenbackd [at] gmail [dot] com. I welcome all feedback. Connect on LinkedIn, where we’re Friends.
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