The Rate of Return on High and Low P/E Ratio Stocks

Abstract

IN THE May-June, 1967, issue of the Financial Analysts Journal, Nicholas Molodovsky reviewed the existing studies on PE ratios. The studies in general supported the view that low PE ratio stocks outperformed high PE ratio stocks in terms of return on investment. However, Molodovsky discussed two procedures, at least one of which was used in each study, which could have inflicted serious bias in the results. The first was the tendency to select stocks for analysis on other than a random basis, i.e., the selection of quality issues by 1960 standards and seeing what has transpired since 1939. The other pertained to the practice of periodic cumulative reinvestment into high and low PE ratio stocks. Molodovsky indicated that this practice magnified any overpricing or underpricing in a specific group. To this should be added the comment that this procedure also promotes statistical interdependence among groups, and considerably complicates any analysis. The study described herein was aimed at eliminating these two discrepancies in studying the rate of return on high and low PE ratio stocks. In addition, it was desired to provide data in regard to the effect of buying in different years and in regard to the appropriate rate of retum.