Which PE Is Best?

Which price-to-earnings ratio is best for screening stocks? In the November 2024 first version of his paper entitled “Forward Price-Earnings Ratio”, Luca Conrads compares the practical abilities of seven price-to-earnings ratios to predict S&P 500 returns (see the chart below for four of these seven):

1. Conventional price-to-earnings (PE) – current price divided by prior-year actual earnings.
2. Cyclically Adjusted Price-to-Earnings (CAPE) – current price divided by average annual inflation-adjusted earnings over the last 10 years.
3. Cyclically Adjusted Price-to-Earnings (CAPE5) – current price divided by average annual inflation-adjusted earnings over the last five years.
4. Forward Price-to-Earnings Analysts (FPE^A) – current price divided by next-year annual earnings as forecasted by analyst consensus.
5. Average Forward Price-to-Earnings Analysts (AFPE^A) – current price divided by average annual earnings over the next five years as forecasted by analyst consensus.
6. Forward Price-to-Earnings Mechanical (FPE^M) – current price divided by next-year annual earnings as mechanically forecasted via ordinary least squares (OLS).
7. Average Forward Price-to-Earnings Mechanical (AFPE^M) – current price divided by average annual earnings over the next five years as mechanically forecasted via OLS.

He each quarter for each ratio ranks all S&P 500 stocks with positive ratios into equal-weighted fifths (quintiles) and applies four separate portfolio strategies:

1.  Assign weights of 30%, 20%, 20% 20% and 10% to quintiles 1, 2, 3, 4 and 5, respectively.
2. Invest only in quintile 1.
3. Modify Strategy 1 by taking a 130% position in quintile 1 and a -30% (short) position in quintile 5.
4. Modify Strategy 1 by taking a 200% position in quintile 1 and a -100% in quintile 5.

He then estimates and deducts quarterly portfolio reformation transaction costs for each ratio-strategy combination. His benchmark is the equal-weighted portfolio of all S&P 500 stocks. Using a broad sample of all listed U.S. stocks and firm fundamentals to evaluate earnings forecasts and a narrower sample of S&P 500 data for strategy tests during 1981 through 2023 (with tests commencing in 1991), he finds that:

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