Want to know how stock performed depending on PER ?

Everybody know what is PER.
Price earning ratio is the stock value divided by its earning per share.

Imagine a stock x has an earning of 200 millions dollars and it has 200 millions shares.
Its earning per share will be 1$.
Lets say its share price is 10$, then this stock has a PER ratio equal to 10.

What does that means ?
Generaly, investor say that a small PER means that a stock is undervalued and a high value of PER means that this stock is overvalued.
That is not true, because it deponds of alot of others things.
- The average ratio of the industry.
- The future growth of the company.
...

In a perfect world a PER of 10 means that the stock will growth at a rate of 10% each year.

Lets take two example :
Stock X who have a PER of 30, a price of 10$ and a earning per share equal to 0.33$
Stock Y who have a PER of 10, a price of 10$ and a earning per share equal to 1$

Which stock will you buy ?

Analyst estimate that stock X will growth in the next 2 years at a rate of 100%, and stock Y at a rate of 5%.

After 2 years, stock X will have an earning per share of 1.33$ (0.33 * 2 * 2)
and stock Y will have an earning per share of 1.1025$ (1$ * 1.01 * 1.01)

Stock X can't growth at this rate all the time, let's say that after two year, these two stocks will have the same PER which is for example 10.

New calculation of stock price after two years:
Stock X : PER = 10 , EPS (Earning per Share) = 1.33 , Price = 13.3$
Stock Y : PER = 10 , EPS = 1.1025$, Price = 11.025$

By buying stock X, you made 33%
By buying stock Y, you made 10.25%

With this example, i wanted to show you that its not a good strategy to always buy low PER.
Because a low PER is probably due to something, nothing happen in the stock market without reason.

But as i will show you know, in average low PER performed better than high PER.

I made a simple backtest for 5 years of data.
I bought all stocks that have :
- Price > 1
- Average Volume daily > 100 000$
- PER > 15
And rebalanced the portfolio each 3 month, so the holding period is 3 month.

Then did another backtest with the same buy criterias but for PER < 15. Here are the results : For 5 years of results.

PER > 15
S&P Perf 6.1%
Backtest Perf 82%

PER < 15
S&P Perf 6.1%
Backtest Perf 151%

As you can see stocks that have PER < 15 performed better.

Both backtest showed a performance better than the S&P ?
Its because stocks in backtest is equaly weighted.
And the S&P is weighted by market cap.

And that will be a topic in few weeks : Small Caps versus Big Caps with backtesting Proof.