The “Growth Stock” Misnomer

Sean Myers stands in a sunlit room with hands in his pockets

This fall has been productive for Sean Myers, an assistant professor of finance at Wharton. His 2022 paper, The Return of Return Dominance: Decomposing the Cross-section of Prices co-authored with Ricardo De la O and Xiao Han has recently won the Rodney L. White Center’s 2022 Marshall Blume First Prize in financial research and the 2023 Best Paper from the Jacobs Levy Center. But what impact will the findings of this paper have on investors?

Professor Myers was kind enough to answer a few questions about his paper and the impact of his findings on the future of finance.

Your paper has received both the Marshall Blume First Prize in Financial Research and the 2023 Jacobs Levy Center Research Paper Frist Prize. These two awards are not only remarkable due to their prestige, but also because they span two different Wharton Finance research centers. Why do you think your paper has been so successful?

Sean Myers: One reason I believe the paper has attracted attention from a broad range of finance audiences is that it tackles a very fundamental question, which is “why do stocks prices differ so much between companies?” For example, why is one company’s price 10 times its earnings while another company’s price is 70 times its earnings?

A common answer to this question is that companies differ in their earnings growth. A company may have a high P/E ratio because its earnings are expected to rapidly grow. This is highlighted by the fact that stocks with high P/E ratios are called “growth stocks.”

In this paper, we show that stocks with higher P/E ratios don’t have substantially higher earnings growth than their peers with low P/E ratios. In other words, calling high P/E stocks “growth stocks” is a bit of a misnomer. Instead, stocks with higher P/E ratios have substantially lower long-term returns than their peers. This result has large implications for market efficiency and the portfolio decisions of long-term investors.

Why is it important for people to know about stock valuation ratios? Can you give an example of how they might affect someone who doesn’t follow financial news too regularly?

Sean Myers: For investors, valuation ratios, like the P/E ratio, are a useful way to gauge how “cheap” or “expensive” a stock is. Buying shares in a company entitles you to a portion of all of the company’s future profits, so a natural benchmark for evaluating prices is to compare the price of the company to the amount of profits it’s currently generating.

More broadly, valuation ratios are important for determining how much money companies can raise. Companies or industries with high P/E ratios will be able to sell their shares for a high price even if they don’t have particularly high current earnings. This makes it relatively easier for them to raise money to hire more employees and expand their businesses. Thus, even if you are not investing in stocks, valuation ratios can affect which companies/industries are hiring and how big a role each company/industry plays in the overall economy.

How do you anticipate your findings will affect the way people think about long-term investing?

Sean Myers: Our work emphasizes the importance of distinguishing long-term returns from short-term returns. People have often looked at the short-term returns of Growth stocks (i.e., high P/E ratio) compared to Value stocks (i.e., low P/E ratio). In particular, for the last two decades, Growth stocks have had similar or even higher short-term returns than Value stocks. However, our work shows that if we consider long-term buy-and-hold returns for horizons of 5 to 10 years, then high P/E ratios stocks have significantly lower returns than their low P/E ratio peers. This highlights that while P/E ratios may not be a strong indicator of short-term returns, they are still very relevant for predicting long-term returns.

Rephrased, our work reinforces the idea that stock fundamentals are a large determinant of long-term returns. Short-term returns may be influenced by momentum or swings between “risk on” and “risk off” investor sentiment. In comparison, long-term returns largely boil down to (i) the price at which you purchased the stock and (ii) the subsequent long-term fundamental growth (e.g., earnings growth) of the company. There will always be exceptions but, in general, it is difficult to generate a high long-term return if you purchase companies with high P/E ratios that don’t go on to have high long-term earnings growth.

What kind of impact do you hope your research will have on the financial community?

Sean Myers: We hope our findings will cause long-term investors to look more critically at companies’ P/E ratios. If a company has a high P/E ratio, say of 70 to 90, an investor should seriously assess what kind of earnings growth would be needed to justify this high price and whether they believe the company will achieve that kind of earnings growth. For example, does the investor realistically think the company will quadruple its earnings in the next five years?

Our results indicate that, in general, high P/E ratio stocks do not have high enough future earnings growth to justify their high initial P/E ratios. Instead, high initial P/E ratio stocks are mainly characterized by low long-term returns. This means that long-term investors should only purchase these stocks if (i) the stock hedges some kind of important risk that the investor cares about and the investor is willing to accept a lower return because of this or (ii) the investor thinks they have found an exception to our result.

Regarding this latter option, our results do not state that every high P/E ratio stock goes on to have low long-term returns. There are certainly some high P/E stocks that have gone on to have extremely high subsequent earnings growth and high subsequent long-term returns. Our results simply state that these companies are the exception rather than the norm. Thus, investors looking to buy high P/E stocks should be very selective in which companies they choose.

Learn more about Sean Myers and his findings on Knowledge at Wharton.

Read about the Marshall Blume Prizes.

Learn more about the Jacobs Levy Center Research Paper Prizes.