I recently came across an interesting fact in Value Investing: from Graham to Buffett and Beyond about the relationship between the price to earnings ratios (P/E) of small cap companies and the market. According to the authors of the book,
“[G]enerally the small caps P/Es are higher, befitting their more realistic prospects for growth. In 1983, . . . the small cap P/E ratio reached a pinnacle of more than 2.3 times the P/E of the S&P 500. . . . By the end of 1998, the ratio had fallen along a very jagged course to around 1 to 1.”Bruce Greenwald, Judd Kahn, Paul Sonkin, and Michael van Biema, “Value Investing: from Graham to Buffett and Beyond,” John Wiley & Sons, 2002, p.23.
What they mean is that small cap stocks were more overvalued than larger ones in the 1980s, and then became valued at the same level as the latter. I wonder what the relationship would look like in today’s market.
The P/E Ratio
Price to earnings ratio (P/E) is one of the popular measurements for valuing a company. It is calculated with the following formula:
In other words, P/E ratio represents how much money you are willing to pay for the earning of a company’s share. A relatively high P/E ratio is a sign of overvalue while a low P/E a sign of undervalue. Usually, analysts use earnings trailing twelve months (TTM) instead of the earning reported in the last quarter in the calculation to mitigate short term or seasonal fluctuations in earnings. Long term investors may even use earnings in the past 10 or 30 years.
P/E is also found to be related to stock return. For instance, Robert Shiller indicated in his Irrational Exuberance that low P/E ratio can be a good predictor for long-term return (see chart below too).
P/E Breakdown by Market Capitalization
For the purpose of stock screening, I’m interested in the relations between P/E and company size. Given that sizable companies tend to attract institution investors, it shouldn’t surprise anyone that smaller companies have lower P/E ratios than bigger ones. To test this hypothesis, I analyzed the dataset used for generating the September 4 Sprout Undervalued Index reports.
The dataset contains P/E ratios for 3,072 stocks from 11 different sectors that are currently traded in the US (some are omitted due to missing data). The median P/E ratio of all the stocks is 20.04. The reason I focus on median rather than mean P/E ratio is that the distribution of the ratios in the dataset is highly skewed. So, median is a better statistic to measure the average P/E of the dataset than mean (FYI, the average P/E of the dataset is 83.38). The table below describes the stocks in the dataset. the market is quite well distributed, with the small cap stocks accounting for the most (30.05%) of the market. The median P/E ratios for different company sizes generally confirm our hypothesis, that is, the larger companies become, the higher P/E they have, except for mega size companies.
|Number of Stocks||Percentage of All Stocks|
P/E by Sectors and Market Capitalization
Examining the data further to take into account both market capitalization and the 11 sectors, we present the results below (all P/E ratios are median statistics of the respective category; the values without parentheses are P/E ratios; the values within parentheses are the total number of stocks in that category):
With a glance at the overall P/E ratios, the positive impact of company size on P/E ratio generally remains for nearly every sector, which means undervalued stocks are more likely to be found among smaller companies than bigger ones (if you could find an undervalued large company, then you must grab that opportunity without any hesitation).
The two somewhat exceptions of this pattern are health care and consumer staples sectors. In health care sector, the P/E rations of its mega cap companies are at the similar level of those of micro cap companies. Similarly, mega cap companies in the consumer staples sector has similar P/E to small caps. Given that there are few mega cap companies in the two sectors, median value may not be representative. With further investigation, the four mega health care companies that have low P/E ratios are: JNJ (P/E: 27), PFE (P/E: 14.7), UNH (P/E: 18), and MRK (21.15); and the four in the consumer staples sectors are: WMT (23.55), UN (22.21), KO (24.14), and PG (28.32). Among them, I think PFE and UNH seem to deserve most further investigation.
Comparing among sectors, the two sectors that have the lowest P/E are energy and financials, while the two sectors with the highest P/E are information technology and real estate. The fate of energy and financials sectors are closely connected to the economic development in the country. As the development of vaccine to the COVID-19 progresses, now would be a good time to screen undervalued stocks in these two sectors. Check out the most undervalued stocks in financials and energy sectors.