Is buying high earnings-to-price (or low PE) stocks a good strategy?

Reader's Question: Is buying stocks with high earnings-per-share (EPS) as a percentage of stock price a good investment strategy? I am considering investing in a Bombay-listed Indian bank (current share price of 85 rupies) whose EPS has been about 15% of share price for the past three years. If this trend continues, will I be able to receive my initial investment back through EPS over the next six to seven years? Will all the EPS be deposited into my bank account?

Low PE: An Entree into Low PEG

We can restate your main question in more familiar stock market jargon by inverting your earnings-to-price percentage to get a price-to-earnings ratio: Does buying stocks with low price-to-earnings ratios (P/E) produce higher returns? A wealth of literature exists on this topic of low-PE stocks within the framework of value investing. Rather than rehash the basics, I cite an article available online--This Stock Is So Cheap! The Low Price-Earnings Story--for your edification and perusal. The author of the article draws this conclusion:

The conventional wisdom is that low PE stocks are cheap and represent good value. That is backed up by empirical evidence that shows low PE stocks earning healthy premiums over high PE stocks. If you relate price-earnings ratios back to fundamentals, however, low PE ratios can also be indicative of high risk and low future growth rates. . . . [A] strategy of investing in stocks just based upon their low price-earnings ratios can be dangerous. A more nuanced strategy of investing in low PE ratio stocks with reasonable growth and below-average risk offers more promise, but only if you are a long-term investor.

To the above, I would add that I tend to favor "low PEG" as a more useful indicator of potential upside than low PE. Since PEG is the "super-ratio" of price-to-earnings ratio divided by earnings growth rate ("PEG" = PE/G, where "PE" = P/E), PEG embodies a growth component that PE lacks. In other words, by considering low PEG stocks, investors can concurrently select both good current value (relatively low PE) and good expected growth (relatively high G). For a discussion of stock returns, EPS growth, PE and the importance of low PEG, please have a look at an earlier blog entry.

Investment Cash Flow: Fixed-Income vs. Stocks

If you could find a fixed-income investment that pays 15% current interest (some junior mortgages on real estate and certain junk bonds pay this type of return, though both involve considerable payment default risk), your annual scheduled investment cash flows would be what you have in mind: 15 dollars (or rupies if in India) for every 100 dollars (or rupies) of principal invested. Further, given a seven-year maturity, you would (assuming the borrower does not default) receive more than your initial investment back in interest payments (7 years x 15% = 105%), which, when combined with your principal, would actually amount to total cash flows of 205% (105% interest + 100% principal) over the full holding period.

Unlike fixed-income investments, stocks do not have any pre-scheduled set of cash flows. Although you might be able to buy a stock at an earnings-to-price percentage of 15% (PE of 6.7), there is no direct linkage between your investment cash flows and the company's earnings. Instead of making pre-scheduled payouts to equity investors, companies pay periodic (usually quarterly or semiannual) dividends which are typically some fraction of earnings. Based on earnings results, availability of cash flow and company policy, management can raise or lower dividends from one period to another.

With the exception of very long, multi-decade investment horizons, the primary determinant of your returns from stock investing will be, not dividends, but the terminal market value of the stock when you sell it (or simply wish to calculate your mark-to-market "paper profits" without actually selling). The uncertainty of the future price of a stock is what makes stock investing risky business but also has the potential of delivering great financial rewards to those who succeed over the long haul.

In your example of buying an Indian bank stock (possibly Andrha Bank?) at 85 rupies, your investment cash flows would consist of relatively small dividends, amounting to about two or three rupies per share per year. Whenever you decide to sell your shares, you will receive whatever the market price is at the time of sale, which, of course, can be either higher or lower than 85 rupies and will typically become the main component of your net profit or loss over your holding period. Both dividend payments and proceeds from sale of your shares will end up in your brokerage account and can then be transferred to your bank account if you so desire.