To P/E Or Not To P/E

by: InvestorsEdge


Is the P/E ratio the best indicator to use to identify undervalued companies?

We test 9 popular ratios to see if they can successfully identify hidden gems.

We’ll show you a simple yet powerful trading strategy that has returned 17% a year since 2000.

(Update 7/3/2017 6:40 a.m. This article has been updated to correct several data errors in the original.)

The humble P/E ratio is possibly the most popular measure of valuation of a stock. In a very limited and admittedly unscientific poll, 5 of the top 10 trending articles on Seeking Alpha today at 2.25am ET mention the ratio and use it as part of the author's analysis and subsequent recommendations.

But is its popularity justified? Can the simple division of a stock's share price by its earnings add any value as we analyze a business? And if it does, is it the best metric to use?

Our Baseline

Let's see how the P/E ratio performs in real life; what would happen if each month we bought the 30 US stocks with the lowest P/E ratios?

We'll use the platform to simulate trading our strategies historically. More graphs and statistics on all the models that we discuss in this article can be accessed here (to view the tests performed on different ratios click on the history tab and navigate to a different model).

Let’s start by backtesting the following trading strategy:

  • Our tradeable universe will include all common stocks in the US with a minimum market capitalization of $50 million.
  • We will rebalance our portfolio on a monthly basis.
  • At each rebalance point we will buy the 30 stocks with the lowest P/E ratio.
  • Each transaction will cost a flat fee of $7.
  • We will simulate using a Market On Close order to buy stocks at their closing price on the next trading day after the rebalance.

Here's how the strategy performed, benchmarked against the S&P 500: P/E ratio performance

Our strategy would have given us a return of just 2% a year over the 17 year test period, which is pretty awful when compared to the S&P 500 which has managed a 3% annual gain over the same period. P/E Ratio Drawdowns

The drawdowns chart highlights the issue. The above chart shows the drops in value of our simulated portfolio – this is not a strategy that will help you sleep well at night.

Ok, a quick glance at the statistics tells us that the P/E ratio doesn't exactly give us stellar returns - what other factors can we use?

Back to Basics

Let's start our analysis by working out what we are trying to achieve with our ratios. First and foremost, financial ratios allow us to compare the historical and/or estimated performance of securities from different industries to each other.

Secondly, ratios are also often used to imply or predict imminent changes in share price. In the experiment above we are hypothesizing that the stocks with the lowest P/E values will see an above average gain in their share prices over others at each monthly rebalance of the strategy.

So, how do other ratios stack up against the P/E ratio?

Ratio comparison Above you can see the results of re-running our backtest and substituting the P/E ratio with a series of 7 other factors. You can see the gray P/E line wasn’t the worst performing factor.





















Price / Cashflow





Price / Sales




















Price to FCF





PEG Ratio

The PEG Ratio takes the P/E ratio and divides it by the consensus analyst estimate for future earnings growth (we have used the estimated 1 year EPS figure in our model).

Using the PEG ratio would have destroyed the vast majority of our capital within 4 years.


Price to Book represents the value per share left over for shareholders if the company was liquidated. This factor has the lowest win rate (the percentage of winning positions vs losing ones) out of the whole study, and once again would have destroyed our capital within 4 years.

Price to Cash Flow

Cash flow represents the total amount of cash and equivalents being transferred into and out of the business. Companies with low price to cash flow levels are possibly undervalued as they have low prices and proportionately high levels of cash flows that can be reinvested.

Price to Sales

Calculated by dividing the current share price by a company’s sales per share, price to sales ignores earnings and focuses on revenues, the theory behind this being that companies that turn their businesses around and avoid bankruptcy tend to see an uptick in sales before earnings.

Ebit and Ebitda / EV

Divides a company's income by its enterprise value, a popular way of valuing a company. Of the two ratios, Ebit performed the best.


Free cash flow is the total amount of cash and equivalents being transferred into and out of the business after capital expenditures have been accounted for and is generally thought of as a 'truer' representation of the cash-generative abilities of a business than cash flow.

Because of this, it is no surprise to see FCF occupying the top two positions of our test - companies with low price to free cash flow ratios are potentially cheap because they have low prices and proportionately high levels of free cash flows that can be reinvested.

Dividing a company’s free cash flow by its enterprise value would have returned us 13.5% annually.

And the Winner is...

The clear winner was the Price to Free Cash Flow ratio, calculated by simply dividing a security's price by its free cash flow per share. Using this ratio shows theoretical returns of 17%, with slightly higher drawdowns and volatility than FCF/EV.
Price to FCF results

The drawdowns for this strategy look very different from that of the P/E Ratio - the value of our holdings only dips by 10-15% in normal trading with 4 larger drops in 2002 (the dotcom bust), 2008 (the great financial crisis), 2011 (the euro crisis) and 2015 (the oil crisis).

Price to FCF drawdowns The 2007-8 financial crisis hit this strategy hard, experiencing an 80% drawdown compared with the S&P 500’s decline of 57%.

Would We Trade This Strategy?

So, shall we all go out and buy the 30 stocks in the US market with the lowest price to free cash flow figures? Let's delve into the risks that doing so could entail.

For us to execute a trading strategy in real life we need to have good reason to trust that it will continue to be profitable. To help us decide the likelihood of this we have four high level tests that our model should pass:

  • Investable - the strategy should be tradeable in real life and should scale. Our backtests include trading fees, so frictional costs are already taken into account. A key concern is in the scalability of the strategy as it its positions are concentrated on micro-cap stocks ($50-300m market capitalization). However, increasing our minimum market capitalization requirement to $300m still would have returned 16% annually, so Pass.
  • Intuitive - there should be logical risk- or behavioral-based reasons that the strategy works. While all our ratios are logical risk-based factors, no consideration is being made to select companies that are mis-priced compared to those that are junk. Fail.
  • Persistent - The factors involved should work over long periods of time. While our tests have concentrated on the 2000-17 period, numerous studies have found similar behaviors in studies from at least 1962 onwards. Pass.
  • Pervasive - Pervasiveness is more an ideal than a hard rule - our model should work across countries, regions and sectors. The chart below show the performance is replicated across most other countries we tested, so Pass:

International results for Price to FCF Your Takeaway

While this is only the beginning of our study into value ratios, this evidence shows us that there are better factors to use when considering which stocks to buy than the P/E ratio.

However, despite some double-digit gains, no single ratio would have provided a comfortable ride over the last 17 years.

In our next article, we will investigate more complex factor combinations to improve the robustness of our model, with a view to designing a value trading strategy that we could actually trade with.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.