The PE Ratio Debate, Decoded

At Qode, every investment thesis is tested through data, not intuition. As part of our ongoing research initiatives, we conducted a detailed study to revisit a classic investing question: 

Do low PE (value) stocks consistently outperform high PE (growth) stocks? And does this relationship hold uniformly across different market capitalizations? 

This blog outlines the methodology, key findings, and implications of this study, based on a robust 15-year backtest. 

Study Design and Methodology

We evaluated the relationship between PE ratios and forward returns across four distinct market cap buckets: 

₹100-1,000 Cr 
₹1,000-10,000 Cr 
₹10,000-50,000 Cr 
₹50,000 Cr and above 

The test period spanned from April 2009 to March 2023. At each month-end during this period, we:

• Filtered companies that met the market cap and profitability criteria (PAT > 0).
• Sorted the filtered stocks based on their P/E ratios.
• Split the universe into two portfolios: the top 50% (high PE) and the bottom 50% (low PE).
• Calculated rolling forward 1-5 year CAGRs for each portfolio.
• Aggregated the performance over the entire backtest horizon.
  
  The following chart illustrates how often each portfolio outperformed within its respective market cap segment.

Key Observations:

Below is a visualization of the 1-year average rolling returns of different market-cap buckets: Low-PE portfolios have outperformed High-PE portfolios

We see that

• Whenever the returns are higher (very bullish 1-year period), low PE portfolios have outperformed high PE portfolios.
• Whereas during periods where the returns are not very high, low PE & high PE portfolios have performed almost the same. We cannot see any instance where the high PE portfolio has outperformed the other.

We found that 64% of the time, a lower PE portfolio has given more returns than a higher PE portfolio.

Thus, we can say that the lower PE portfolio has performed better than the other here.

We see that

• There is a similar pattern in this as seen in the previous case.
• The only difference is that for periods with lower returns, a higher PE portfolio makes a little more than a lower PE portfolio. Though the instances are almost at the same level.

We found that 52% of the time, a lower PE portfolio has given more returns than the higher PE portfolio (which can be considered as 50-50%).

The number has decreased from the previous backtest value (69%).

Even though the number of outperformances has decreased, we can still say that the lower PE portfolio has performed better than the other here too.

Though we see a linear trend in both of the portfolio returns, there is no dominance that one portfolio shows higher returns at any time. The data is pretty much random.

We found that 40% of the time, lower PE portfolios have given more returns than higher PE portfolios, i.e., higher PE portfolios beat lower PE portfolios 60% of the time.

The previous CAGR numbers also show that, in this market cap range, a higher PE portfolio beats the other.

Though there is no significant outperformance in the amount of returns by the higher PE portfolio, due to the number of months it outperformed the other portfolio, we can say that it has performed better than the lower PE portfolio.

We cannot see any definite trend or pattern in this plot, though there is a slight linear upward trend, but nothing can be said about one portfolio outperforming the other yet.

The data is pretty much concentrated in a given range. We found that 43% of time lower PE portfolio has given more returns than a higher PE portfolio, i.e. higher PE portfolio beats a lower PE portfolio 57% of the time.

The previous CAGR numbers also show that, in this market cap range, a higher PE portfolio beats the other by great margins.

Though there is no significant outperformance by the higher PE portfolio, due to a number of months it outperformed the other portfolio, we can say that it has performed better than the lower PE portfolio.

Conclusion

The results of this long-term study demonstrate that valuation does matter, but its effectiveness varies by company size. 

• In small and mid-caps, focusing on valuation remains a reliable approach.
• In large caps, premium valuations are often justified by higher quality, growth, or capital efficiency, making traditional PE-based screening less predictive.

As always, valuation should not be viewed in isolation. A context-aware, multi-factor approach yields better outcomes over time.