These investments will boost your net worth more than any growth stock

By Sean Myers

Why value stocks with low P/E ratios deliver long-term

High P/E ratios mainly signal low future returns rather than high future earnings growth.

Long-term investors who are considering buying "growth stocks," i.e., stocks with high price-earnings (P/E) ratios, may want to think again. The phrase "growth stocks" appears to be a misnomer.

In general, differences in future earnings growth are fairly modest between high P/E and low P/E stocks and are far too small to justify the large differences in prices between those two sets of stocks. On average and over the long run, high P/E stocks deliver significantly lower returns than low P/E stocks.

What do P/E ratios imply? The ratio of a firm's price to its earnings is one of the most common metrics used to evaluate a stock. A high P/E ratio could indicate that a stock's earnings are expected to grow rapidly in the future. For this reason, high P/E stocks are typically called "growth stocks." Alternatively, a high P/E ratio could indicate that a stock is overpriced and will have low returns in the future.

Retail investors lured by stocks with high price multiples must scrutinize the fundamentals. A safer bet is to pick value stocks with low P/E ratios that deliver long-term.

In research with my co-authors, Ricardo De la O and Xiao Han, we evaluate these two possibilities. We track long-term buy-and-hold earnings growth and returns for all listed U.S. stocks from 1963 to 2020 over 15-year rolling periods. The results clearly show that differences in returns between high P/E stocks and low P/E stocks are much larger than the differences in earnings growth. In other words, high P/E ratios mainly signal low future returns rather than high future earnings growth.

The growth stock misnomer

Most high P/E stocks struggle to generate anywhere near enough future earnings to repay their high valuations.

Fundamentally, buying a share in a company entitles you to a portion of that company's earnings. For a buy-and-hold investor, the key question is how these future earnings compare to the price one must pay upfront to purchase a share. For example, a doubling of the price must be matched by a doubling of the future earnings, otherwise the share will deliver lower long-term returns. Similarly, a doubling of the P/E ratio must be matched by a doubling of future earnings growth if the investor wants to earn the same return.

This raises a difficult challenge for high P/E stocks. A stock with a P/E ratio of 75 must quintuple its earnings over the next 10-15 years just to match a stock with a P/E ratio of 15 that has no growth in earnings at all. More realistically, if the stock with a P/E ratio of 15 doubles its earnings over the next 10-15 years, which is a fairly conservative rate of growth, then a stock with a P/E ratio of 75 must 10x its earnings over that same period.

While there are certainly some stocks that achieve this type of enormous growth, these tend to be the exception rather than the norm among high P/E stocks. Using 15-year earnings growth for a large set of stocks, we find that earnings growth for high P/E stocks was only one-fourth the amount required to justify their high P/E ratios. Instead, three-fourths of their high P/E ratios was accounted for by low 15-year returns. In short, most high P/E stocks struggle to generate anywhere near enough future earnings to repay their high valuations.

Takeaways for investors

When choosing stocks, investors should seriously assess P/E ratios, as well as valuation multiples more broadly. What kind of earnings growth would be needed to repay your current investment, and does this seem realistic? Do comparable firms consistently show similar growth? While short-term price movements often attract a lot of attention, it is these more fundamental questions that play a large role in determining long-term returns.

Overall, our results suggest that long-term investors should tilt more towards stocks with low P/E ratios. A small adjustment would be to replace high P/E stocks with lower P/E counterparts within the same sector or industry. These lower P/E counterparts essentially have more room for price growth going forward and will require less growth in earnings to repay the initial investment. A larger adjustment would be tilting towards lower P/E sectors such as utilities or consumer staples.

As always, it is important to diversify across many low P/E stocks rather than concentrating in a single stock. Some stocks may have low P/E ratios because they are distressed or near bankruptcy. However, when assessing a diversified portfolio of low P/E stocks, we find that the risk (i.e., the volatility of 15-year returns) is nearly the same as the risk of a diversified portfolio of high P/E stocks, yet carries a substantially higher average return.

Read: Why you shouldn't be too quick to dump your stocks just yet

When growth stocks deliver

Of course, some growth stocks do phenomenally well and manage to deliver high returns to their investors, in particular investors who bought shares in the company's earlier periods in which there was more room for the price to increase. But it is very hard to find these unicorns.

While we all know of tech giants that rapidly grew to dominate a specific market, don't forget the companies that failed to live up to investors' high expectations and the numerous high P/E companies that went out of business. For every Google (now Alphabet (GOOGL)), there is a Cisco Systems (CSCO), a company that had a P/E ratio of 200 during the late 1990s dot-com boom and whose stock price has still yet to recover to its 2000 highs, along with many like Pets.com that completely shut down.

Unless you can pick the handful of unicorns, the better long-term return strategy seems to be investing in a broad set of low P/E stocks rather than high P/E stocks.

Sean Myers is an assistant professor of finance at the Wharton School at the University of Pennsylvania.

April is National Financial Literacy Month. To mark the occasion, MarketWatch is publishing a series of "Financial Fitness" articles to help readers improve their fiscal health, and offer advice on how to save, invest and spend their money wisely. Read more here.

Plus: Why buying stocks in this hot sector may turn out to be a money-losing bet

Also read: You're likely being wildly unrealistic about how much money stocks can make

-Sean Myers

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04-27-24 1047ET

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