Should You Avoid High P/E?

It has often been advocated to avoid any stocks with a high P/E. The common argument is that you would be overpaying for hype stocks.

However, overpaying or not depends on how the high P/E stocks behaves in future. For example, if high P/E stocks actually do grow at a rate that is significantly higher than low P/E stocks, then it is arguably justifiable to buy stocks with a high P/E. One real-life example for this is Amazon. It has a notoriously high P/E for as long as the stocks exist, however, the stock price has also been growing exponentially.

Of course, this is only one counter example. In this article, I would demonstrate in general if a higher P/E means higher growth in the context of the Singapore stock market.

In particular, I am going to look at the following two dimensions:

1) P/E vs Earnings Change
Does a higher P/E lead to higher earnings change going forward (1 year and 3 years)? By paying for a high P/E, investors are betting that the earnings of the companies will grow significantly such that it is worth paying for the high P/E upfront.

Looking at the two graphs above, it is obvious that as the P/E (x-axis) increases, it does not influence earnings change.

2) P/E vs Total Returns (Price Change + Dividends Gained)
Does a higher P/E leads to higher total returns going forward (1 year and 3 years)? Ultimately, investors want to earn returns on investments. It is certainly worth paying for high P/E if it gives us higher total returns.

Similarly, Figures 3 and 4 above show that as the P/E (x-axis) increases, it also does not affect total returns.

To be more mathematically rigorous, I have computed the Spearman correlation for them as well.

P/E vs Earnings Spearman (1 year): -0.0085
P/E vs Earnings Spearman (3 years): -0.0580
P/E vs Total Returns Spearman (1 year): -0.1437
P/E vs Total Returns Spearman (3 years): -0.1871

What the Spearman correlation tells us is that there is no correlation between P/E and Earnings, and that there is a slight negative correlation between P/E and Total Returns. Essentially, it is saying that the P/E does not influence Earnings, but a higher P/E causes slightly lower Total Returns.

The conclusion of the results is: although it is not worth paying for high P/E, it is not necessary to avoid them completely.

Happy investing!

—

Methodology
For those that are interested in the methodology on how the data points are generated.

1) P/E vs Earnings (1 year)
Taking all end of year P/E between 2010 and 2015, pair it with the change of earnings between then and one year later. Total data points available were 1,292.

2) P/E vs Earnings (3 years)
Taking all end of year P/E between 2010 and 2015, pair it the change of earnings between then and three years later. Total data points available were 410.

3) P/E vs Total Returns (1 year)
Randomly picking ten dates between 2010 and 2015, use the P/E and pair it with the change to total returns between then and one year later. Total data points available were 2,973. Note that total returns is computed by (“one year later close” + “dividends given out during this period”) / “current close” – 1

4) P/E vs Total Returns (3 years)
Randomly picking ten dates between 2010 and 2015, use the P/E and pair it with the change to total returns between then and three years later. Total data points available were 3,430. Note that total returns is computed by (“one year later close” + “dividends given out during this period”) / “current close” – 1

Note that I have also cut off the graph where the P/E is greater than 100 as they are sparse outliers which made the graph harder to view.