In the late 1970s, Sanjoy Basu, building on the work of S.F. Nicholson in 1960, discovered that stocks with low PE ratios have significantly higher returns than stocks with high PE ratios.
This would not have surprised Benjamin Graham and David Dodd, who in their clasic 1934 text, Security Analysis, argued that a necessary condition for investing in common stock was a reasonable ratio of market price to average earnings. They stated:
Hence we may submit, as a corollary of no small practical importance, that people who habitually purchase common stocks at more than about 16 times their averge earnings are likely to lose considerably money in the long run.
Yet even Benjamin Graham must have felt a need to be flexible on the issue of what constituted an excessive PE ratio. In their second edition, written in 1940, the same sentence appears with the number 20 substituted for 16 as the upper limit of a reasonable PE ratio.
What types of PE ratios are justified in today's economy?
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