Testing the Efficiency of Price-Earnings Ratio

in Constructing Portfolio
Ruzbeh J Bodhanwala*

Price-Earnings (PE) ratio is a very powerful indicator in accessing share performance against its competitors or
industry players. This study focuses on constructing portfolios on the basis of PE ratio and measuring its performance
against the benchmark BSE sensex for the last 10 years (2002-2012). BSE index is above 24000+ points and picking
stocks at this level is a risky business. Most of the investors and fund managers believe in picking stocks which are
relatively cheaper than the industry average and therefore PE ratio would play an important role. Using a combination
of statistical tools, it is proved that portfolios formed on the basis of low PE outperform the BSE Benchmark market
returns.

Introduction
In recent years, the Price-Earnings (P/E) ratio has become the most popular approach for
equity valuation. To obtain a fair valuation of corporate stocks, P/E ratio of the company is
multiplied by its expected future earnings. Thus, P/E ratio indicates the average price the
market is willing to pay for purchasing each unit of company earnings and therefore, it should
reflect the earnings quality and industry growth potential.
A lot can be said about the ratio, but a general remark that is made about this ratio is that
if a company is growing and has a higher earning potential, then the P/E ratio will also be
high. P/E ratio is considered as a proxy to the firms growth rate.
Sharpe (1966) introduced a risk-adjusted measure of determining the portfolio performance
referred to as the Sharpe ratio or Reward-to-Variability Ratio (RVAR). Sharpe used RVAR
for the following:
To measure the risk premium, that is, the excess return required by investors,
relative to the total amount of risk in the portfolio.
Rank portfolios performance using the RVAR.
Sharpe returns of a portfolio are compared with the market returns, and thereby, a selection
criterion for constructing an optimum portfolio (i.e., portfolio that outperforms market) on
the basis of fundamental variables is identified. This helps the investors to achieve their
objective of maximizing returns for a specified acceptable level of risk.
Presented at the Eighth National Conference on Indian Capital Market: Emerging Issues, held at IBS
Gurgoan, India, during February 7-8, 2014.
*

Associate Professor, NIIT University, Neemrana, Rajasthan, India. E-mail: bodhanwala@gmail.com

2014 the
IUP.Efficiency
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Testing
Price-Earnings Ratio in Constructing Portfolio

111

Literature Review
The literature review focuses on various fundamental measures, which can help in
constructing a better portfolio, thereby maximizing returns to stockholders and justification
of choosing a particular measure, rather than intuition, and by their popularity among
practitioners.
Nicholson (1960) supports the P/E ratio as a key fundamental variable, which can be used
to select the securities that yield high returns. McWilliams (1966) evaluates the usefulness of
the P/E ratio as an analytical tool.
Basu (1977) examines the relationship between investment performance of equity
securities in the NYSE and their P/E ratios for the period April 1957 to March 1971. The
study establishes that the low P/E portfolios seem to have, on average, earned higher absolute
and risk-adjusted rates of return than the high P/E portfolios.
Jafe et al. (1989) consider a sample period from 1951-1986. The findings indicate the
difference between January and rest of the year. The earning yields effect on stock returns is
significantly positive only in January for the sub-period 1951-1968. And for the sub-period
1969-1986, the E/P effect is significant in January and all the rest of the months. The
conclusions are based on both portfolio and seemingly unrelated regression tests.
Chan et al. (1991) examine the cross-sectional differences in returns on Japanese stocks
to the underlying behavior of four variables: earnings yield, cash flow yield, size and book-tomarket ratio. The findings establish a significant relationship between these variables and
expected returns in the Japanese stock market. Book-to-market ratio and cash flow yield
have the most significant positive impact on expected returns. Earnings yield is replaced by
the cash flow measure because the cash flow variable may be more informative than earnings
yields, since reported earnings are likely to be distorted by accounting divergence between
economic and reported depreciation. This is consistent with the Quality of Earnings
explanation discussed by Bernard and Stober (1989), according to which earnings per share
is more easily manipulated.
The studies carried out by Graham (1934), Nicholson (1960), McWilliams (1966), and
Basu (1977) point out that a better investment performance can be obtained from a portfolio
comprising low P/E ratio stocks in contrast to portfolios made up of high P/E ratio stocks.
Other studies like Jafe et al. (1989) and Chan et al. (1991) indicate that there is no significant
relationship between P/E ratio and returns.

Objective
This paper tries to study whether there is a strong relationship between the stocks with low
P/E ratio and returns or due to efficiency in markets there is no opportunity to make a
portfolio which can generate returns higher than the market.
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The IUP Journal of Applied Finance, Vol. 20, No. 3, 2014

Hypotheses
H0: P/E ratio cannot be used to form better performing portfolios (H0: 1 = 2).
H1: P/E ratio can be used to form better performing portfolios (H1: 1 2).

Methodology
11 portfolios for each year were formed, where all the stocks with zero P/E were first separated
to form a separate portfolio (identified as 0), and all the remaining stocks were divided into
10 deciles. Mean, Sharpe return and standard deviation for each portfolio are calculated.
Also, the mean return and standard deviation of Bombay Stock Exchange (BSE) are calculated.
Levenes test is used to check for the equality of variance.
Two random samples (N1 and N2) with values of Mean1, 1 and Mean2, 2, respectively are
selected for the study. One tail test is applied to test the difference between the means of two
samples at 5% level of significance. Since the number of observations is different in portfolios
versus the BSE, and since there is high standard deviation and unequal variance, the standard
method of Satterthwaite approximation is used.

Results and Discussion

In Table 1, for each year, the portfolios are ranked using the Sharpe Returns. The best
performing portfolio is given Rank 1 and accordingly all other portfolios are ranked. The 11th
rank is given to the worst performing portfolio of the year. As can be seen, relatively on 70%
occasions low PE portfolios are doing much better than higher PE portfolios. In Table 2, for
each year all the stocks are divided in equal deciles and the average return of each portfolio is
indicated. In Table 3, for each year all the stocks are divided in equal deciles and the standard
deviation of each portfolio is calculated. Table 4 indicates the number of stocks in each
decile. Table 5 indicates the standard deviation of the BSE Sensex for the same duration
which is considered in forming portfolio. Table 6 presents the results of hypotheses testing
Table 1: Ranking of Portfolio as Per Sharpe Returns
Portfolio 2003

2004

2005

2006

2007

2008

2010

2011

2012

11

11

10

11

2009
5

10

10

11

10

11

11

10

10

10

11

10

10

10

10

11

11

11

Testing the Efficiency of Price-Earnings Ratio in Constructing Portfolio

113

for average return of portfolio Vs. the BSE return using the one-tail test at 5% significance.
Table 7 indicates the value of 10,000, if reinvested year-on-year in the same portfolio,
assuming the average returns calculated in Table 2 for adjusting the principal invested.
Table 8 indicates the rank of portfolio on the basis of data calculated in Table 7 for the year
2012. As can be seen, in Figure 1, 10,000 invested in 2002 (the low PE portfolio 1) increases
to 443,031, thus generating an annualized return of 46%, which is the highest and thus
ranked 1 in the table.
Table 2: Average Return of the Portfolio Formed On the Basis of P/E Ratio
(in %)
Portfolio

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Negative EPS Stock 0

29

297

15

91

43

11

63

16

Lowest Decile

26

60

451

21

95

23

80

19

17

60

323

31

48

87

12

27

47

285

20

43

10

80

13

24

49

218

25

41

74

22

58

277

16

53

13

79

25

49

197

14

46

14

70

12

37

188

37

61

70

16

42

169

32

61

51

25

143

15

60

15

61

10

85

265

68

21

103

15

11

33

50

47

37

22

Highest Decile
BSE Return

Note: The date of the calculation of the return is the last trading day of June; companies selected had financial
year ending March; Average business return: 18%

Table 3: Risk as Measured by Standard Deviation

Portfolio

2003

2004 2005 2006 2007 2008 2009 2010 2011 2012

Negative EPS stock 0 0.733 1.543

3.698 1.345 3.151 2.100 0.565 1.322 0.697 0.792

Lowest Decile

1 0.720 0.962

4.818 1.082 2.596 1.176 0.526 0.841 0.479 0.315

2 0.460 0.875

3.849 0.964 0.903 0.556 0.356 0.889 1.982 0.420

3 0.644 0.645

4.318 0.669 0.716 0.514 0.368 0.821 0.556 0.307

4 0.548 0.636

1.954 0.841 0.817 0.575 0.746 0.808 0.594 0.510

5 0.590 0.708

3.048 0.693 1.312 0.676 0.347 0.927 0.501 0.598

6 0.832 0.703

2.397 0.639 1.133 0.478 0.331 0.955 0.424 0.740

7 0.558 0.595

2.178 2.309 1.051 0.516 0.544 0.963 0.684 3.621

8 0.437 0.738

2.535 1.325 1.245 0.791 0.367 0.934 0.385 1.302

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The IUP Journal of Applied Finance, Vol. 20, No. 3, 2014

Table 3 (Cont.)
Portfolio

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
9 0.405 0.463

1.630 0.825 0.970 0.685 0.373 1.160 0.839 1.057

10 0.793 4.136

7.463 1.072 1.417 1.297 0.766 3.305 1.408 0.662

BSE Standard Deviation 0.010 0.017

0.010 0.016 0.013 0.020 0.031 0.013 0.011 0.013

Highest Decile

Table 4: Number of Observations in the Portfolio

Portfolio

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

332

263

247

313

270

295

329

574

456

402

78

87

106

148

164

180

180

165

201

201

78

87

106

148

164

180

180

165

201

201

78

87

106

148

164

180

180

165

201

201

78

87

106

148

164

180

180

165

201

201

78

87

106

148

164

180

180

165

201

201

78

87

106

148

164

180

180

165

201

201

78

87

106

148

164

180

180

165

201

201

78

87

106

148

163

180

180

165

201

201

78

87

106

148

164

180

180

195

201

201

10

73

84

102

144

163

173

185

192

197

201

2011

2012

Table 5: BSE Standard Deviation

2003

2004

2005

2006

2007

2008

2009

2010

Standard Deviation 0.0096 0.0175 0.0095 0.0160 0.0132 0.0200 0.0308 0.0132 0.0107 0.0127
of BSE

Table 6: Results of Hypotheses Testing

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

H1

H0

H1

H1

H1

H1

H1

H1

H1

H1

H0

H1

H1

H1

H1

H1

H1

H1

H0

H1

H0

H1

H1

H1

H0

H1

H1

H1

H0

H0

H1

H1

H1

H1

H0

H0

H1

H1

H0

H1

H1

H1

H1

H1

H0

H0

H1

H1

H0

H0

H0

H1

H1

H1

H0

H0

H1

H1

H1

H0

H0

H1

H1

H1

H0

H0

H1

H1

H1

H0

H0

H0

H1

H0

H1

H0

H1

H1

H1

H0

H0

H0

H1

H0

H1

H0

H1

H1

H1

H0

H1

H0

H1

H1

H1

H0

H1

H1

H0

H0

10

H0

H0

H1

H1

H1

H1

H0

H1

H0

H0

Portfolio

Testing the Efficiency of Price-Earnings Ratio in Constructing Portfolio

115

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The IUP Journal of Applied Finance, Vol. 20, No. 3, 2014

10,000

Value of 10,000
invested in BSE

10,000
3,244.7

10

10,000

BSE Index

Highest Decile

10,000

10,000

10,000

10,000

10,000

10,000

10,000

10,000

Lowest Decile

10,000

2002

Negative EPS stock

Portfolio

11,117

3,607.1 4

9,800

10,020

10,893

11,175

12,513

12,176

12,361

12,748

11,731

12,607

9,519

2003

14,779

795.5

18,139

12,492

15,509

15,347

18,583

19,244

18,416

18,753

18,763

20,171

12,266

2004

22,171

7,193.9

66,257

30,404

41,681

44,243

55,221

72,515

58,550

72,118

79,295

111,058

48,682

2005

32,697

10,609.3

68,265

34,900

54,869

60,833

63,069

83,936

73,363

86,734

104,072

134,376

55,983

2006

44,702

14,504.6

114,744

55,709

88,149

97,641

91,885

128,291

103,312

123,663

154,051

262,053

107,189

2007

41,488

13,461.6

139,044

53,997

85,606

90,379

84,664

125,248

99,903

119,777

155,892

321,107

153,101

2008

44,669

14,493.8

134,994

45,664

79,266

85,961

72,768

108,750

94,398

107,433

142,484

299,538

136,675

2009

2010

54,553

17,700.9

274,180

73,452

119,329

145,991

123,618

194,757

164,414

192,897

266,559

538,933

223,006

Table 7: Mean Returns of Investing 10,000 in Different PE Deciles (2002-2012)

58,082

18845.9

297,535

73,265

109,594

139,444

115,664

182,885

163,566

203,330

297,923

544,214

205,304

2011

53,718

17,430.0

252,781

67,877

104,431

161,871

112,089

168,846

149,080

177,856

273,707

443,031

172,847

2012

Table 8: BSE Annual Return

Portfolio

CAGR (%)

Rank

33

46

39

33

31

33

27

32

26

10

21

11

10

38

Figure 1: Average Return of Investing 10,000

in Different PE Deciles (2002-2012)
600,000
1

Average Return ( )

500,000
400,000
300,000
0

200,000

3
7 46
8
9

100,000
0

2
10

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

For the portfolio with low PE ratio (portfolio code as 1), alternative hypothesis has been
accepted 8 out of 10 times and this is conclusive that portfolios formed on the basis of low PE
ratio outperform the BSE benchmark market returns.
Even for the stocks where EPS was negative (portfolio code as 0), alternative hypothesis
has been accepted 9 out of 10 times and this is conclusive that portfolios formed on the basis
of low PE ratio outperform the BSE benchmark market returns.
Testing the Efficiency of Price-Earnings Ratio in Constructing Portfolio

117

If we look at years 2005 and 2010, the alternative hypothesis has been accepted for all the
portfolios which means that in those years returns across the board were abnormal and low
PE stocks were not superior to high PE stocks.
Further, low PE portfolio has generated a Compounded Average Growth Rate (CAGR) of
46% versus the Bombay Stock Exchange Return of 18% (an excess return of 28%).
The results indicate that 10,000 invested in the lowest PE stock would yield an annualized
return of 46% and the ranking also suggests that higher returns can be achieved by investing
in low PE stocks.

Conclusion
It is established that between 2002 and 2012 the Indian markets were not efficient and
investing in relatively low PE stocks would yield higher returns verses investing in high PE
stocks, though generally high PE stocks also have high growth rates.

References
1. Basu S (1977), Investment Performance of Common Stocks in Relation to Their
Price-Earnings Ratios: A Test of the Efficient Market Hypothesis, The Journal of Finance,
Vol. 32, No. 3, pp. 663-682.
2. Bernard Victor and Thomas Stober (1989), The Nature and Amount of Information in
Cash Flows and Accruals, Accounting Review, Vol. 64, pp. 624-652.
3. Chan Louis C K, Yasushi Hamao and Josef Lakonishok (1991), Fundamentals and Stock
Returns in Japan, The Journal of Finance, December, pp. 1739-1764.
4. Jafe Jaffrey, Ronald B Kelin and Randolph Westerfield (1989), Earnings Yields, Market
Values, and Stock Returns, The Journal of Finance, Vol. XLIV, No. 1, pp. 135-148.
5. Graham Benjamin and Dodd David (1934), Security Analysis, The McGraw-Hill Companies,
Inc., USA.
6. McWilliams James D (1966), Prices, Earnings and P-E Ratios, Financial Analysts Journal,
May-June, pp. 137-141.
7. Nicholson Francis S (1960), Price-Earnings Ratio, Financial Analysts Journal, Vol. 16,
July-August, pp. 43-45.
8. William Sharpe F (1966), Mutual Fund Performance, Journal of Business, January,
Supplement on Security Prices, pp. 119-138.

Reference # 01J-2014-07-08-01

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