Why a low P/E doesn’t always mean a stock is cheap
The price-to-earnings (P/E) ratio has long been one of the most widely used measures in determining whether a stock is cheap or expensive.
We often read in market commentaries and analyst reports that a stock may be considered attractive if its P/E ratio is lower than that of the market or its comparable companies. Analysts also compare a stock’s current P/E with its historical average to show how undervalued it may be and how much potential upside it could offer.
The same approach is frequently applied to the stock market. Fund managers often point to the P/E ratio of the Philippine Stock Exchange Index (PSEi), which is trading significantly below its historical average.
There is some basis for this practice. In 1977, a landmark study by Sanjoy Basu published in the Journal of Finance found stocks with low P/E ratios tended to generate higher risk-adjusted returns than stocks with high P/E ratios. The study provided early empirical support for what would later become known as the value effect.
However, we often forget that when we compare P/E ratios, we assume the conditions that influenced those valuations have not changed considerably.
One way to understand P/E better is to look at it from another perspective. If a stock trades at 10 times earnings, investors are paying P10 for every P1 of earnings. If we invert the ratio, the same stock would have an earnings yield of 10 percent.
For example, Ayala Corp., which trades at about five times earnings, has an earnings yield of about 20 percent. In contrast, International Container Terminal Services, Inc. (ICTSI), which trades at about 27 times earnings, has an earnings yield of only about 4 percent.
Why would investors require an earnings yield of about 20 percent from Ayala Corp. while accepting only about 4 percent from ICTSI?
In a simple valuation framework, the earnings yield can be viewed as the return investors require from owning the stock less the long-term growth they expect from its earnings.
This means the higher the required return, the higher the earnings yield and consequently the lower the P/E. Conversely, higher expected earnings growth allows investors to accept a lower earnings yield and pay a higher P/E.
We can see how this works by comparing Ayala Land (ALI) and Semirara Mining (SCC) using their trailing 12-month earnings through the first half of this year. ALI trades at about 5.9 times earnings, while SCC trades at about six times.
Both stocks, therefore, have earnings yields of about 17 percent. Based on P/E alone, investors may conclude the two stocks are similarly valued, but the returns investors require from each stock are very different.
If we consider their respective risk profiles, together with the prevailing 10-year Philippine bond yield of 7.3 percent and an estimated equity risk premium of 6 percent, ALI’s required return is about 16.4 percent compared with only 9.4 percent for SCC.
By deducting ALI’s earnings yield of about 16.8 percent from its required return of 16.4 percent, we get an implied long-term earnings growth rate of about negative 0.4 percent, which essentially suggests little to no growth.
For SCC, deducting its earnings yield of about 16.6 percent from its required return of 9.4 percent gives an implied long-term earnings growth rate of negative 7.3 percent.
This does not mean their earnings will necessarily decline every year at these implied rates because our estimates may not capture all the business risks associated with each company. Nevertheless, the comparison demonstrates why two stocks with almost identical P/E ratios do not necessarily reflect the same growth expectations.
We can apply the same principle to the Philippine stock market. The median P/E ratio of the PSEi is currently about 8.5 times earnings.
At first glance, this appears very cheap, especially compared with the higher valuation multiples of other markets in the region. Analysts often point to the valuation discount of Philippine stocks relative to their Asian peers as evidence that the market is cheap.
But just as we cannot conclude one stock is cheaper simply because it has a lower P/E, we cannot make the same conclusion when we compare stock markets.
At 8.5 times earnings, the median P/E of the PSEi translates into an earnings yield of about 11.8 percent. If we deduct this from the market’s median required return, which is also around 11.8 percent, the implied long-term earnings growth is practically zero.
The market’s low P/E is therefore telling us that investors are demanding relatively high returns because of prevailing economic uncertainty and political risks, while expecting little to no long-term earnings growth. Investors are also less willing to pay the valuation multiples they accepted in the past.
For the market to prove that it is truly undervalued, companies will need to show stronger prospects for long-term earnings growth, while the investment environment must improve to lower the risks investors currently price into the market.
Henry Ong is a registered financial planner of RFP Philippines. To learn more about investment planning, attend 118th batch of RFP Program this October 2026. To register, e-mail info@rfp.ph.
