# Valuation of Growth and Value Stocks with PE Ratios

Question:   The chart below contains the frequency distribution for trailing and forward PE ratios for 33 growth firms and 31 value firms.  The data was collected from the top 35 positions from two ETFs – VUG Vanguard large cap growth and VTV Vanguard large cap Value funds. Two growth stocks and four value stocks were omitted from the analysis because of negative earnings, which leads to an undefined PE ratio.

What can we learn about the relative valuations of growth and value firms from this chart?  How did the omission of firms with negative earnings impact our conclusions?  How do conclusions based on trailing PE and forward PE ratios differ?  What are the economic implications of large differences between trailing and forward PE ratios?

The Data:

 Trailing PE Ratios Growth Stocks Value Stocks Freq. Percent Freq. Percent Under 15 5 15.15 6 19.35 15 to 25 10 30.3 11 35.48 Over 25 18 54.55 14 45.16 Total 33 100 31 100 <=75 28 84.85 25 80.65 >75 5 15.15 6 19.35 Total 33 100 31 100 Forward PE Ratios Freq. Percent Freq. Percent Growth Stocks Value Stocks Under 15 5 15.15 25 80.65 15 to 25 19 57.58 6 19.35 Over 25 9 27.27 0 0 Total 33 100 31 100 <=75 31 93.94 31 100 >75 2 6.06 0 0 Total 33 100 31 100

Short Answer:  Analysts on television routinely discuss PE ratios when talking about the valuation of the market.   Their analysis does not specify how PE ratios are assigned to firms with negative earnings or whether these firms are omitted from the sample.   The analyst often fails to state whether his analysis is based on trailing or forward PE ratios. Many analysts routinely present statistics, which understate the extent stocks are overvalued.

Observations about Growth and Value Firm PE Ratios

54 percent of growth firms and 45 percent of value firms report a trailing PE ratio greater than 25.

27 percent of growth firms and 0 percent of value firms report a forward PE ratio greater than 25.

15 percent of growth firms and 19 percent of value firms report a PE ratio greater than 75.

6 percent of value firms and 0 percent of growth firms report a forward PE ratio greater than 75.

Discussion of Growth and Value PE Ratios

I have not reported mean PE ratios because of outliers.  The max PE ratio for value firms in our sample was 272 for growth firms and 2352 for value firms.

The exclusion of firms with negative PE ratios makes it very difficult to measure and compare valuations.   Many analysts top-code firms with large or negative PE ratios.  One way to deal with this issue is to look at the earnings to price ratio (the reciprocal of the PE ratio) or to use techniques mentioned in a previous blog.

https://financememos.com/2017/10/11/two-ways-to-calculate-a-portfolio-pe-ratio/

This analysis substantially understates the current overvaluation of value firms.  Why do I say that?

• First, more value firms than growth firms have negative earnings and have been excluded from the sample. The excluded negative earnings firms are arguably more overvalued than firms with low positive earnings and a high PE ratio.
• Second, as noted the PE outlier is larger for the large cap value sector than the large cap growth firms.

A valuation analysis based on PE ratios does not always result in a larger bias for value firms than growth firm.   A comparison of small cap growth to small cap value firms might find more growth firms with negative or astronomic PE ratios than presented here for the comparison of the two large-cap portfolios.

The lower forward portfolio PE ratios are the consequence of an optimistic assumption on earnings growth.   As shown in a previous post one estimate of projected earnings growth is 100*(PET/PEF)-1 where PET is trailing PE and PEF is forward PE.

http://www.dailymathproblem.com/2018/09/financial-ratio-math.html

 Projected Growth Rate in Earnings from the Comparison of Trailing and Forward PE Ratios Growth Stocks Value Stocks Min -45.1 -51.6 Max 1,615.9 16,146.5

The comparison of trailing and forward PE ratios implies substantial dispersion in projected earnings growth.

It is very easy for an optimistic analyst or an analyst who wants to sell stock to juice forward earnings and make valuations seem more reasonable than they are.

Concluding Remark:

PE ratios are often imprecise measures of firm valuation, especially when earnings are low.   Analysts are using forward earnings estimate to obtain a more optimistic picture of the overall market valuation.  But are these estimates valid or reasonable?

This site uses Akismet to reduce spam. Learn how your comment data is processed.