Investment Performance of Common Stocks in Relation to Their Price-Earnings Ratios
Source: Basu (1977) · The Journal of Finance · DOI: 10.1111/j.1540-6261.1977.tb01979.x
TL;DR
Stocks with low price-to-earnings ratios (high earnings yield, E/P) earned higher risk-adjusted returns than high-P/E stocks over 1957–1971 — the "P/E effect." This is the earliest clean documentation of the value premium using an earnings-based valuation ratio, and an early empirical challenge to the efficient markets hypothesis.
What anomaly it documents
Predictor: earnings-to-price ratio (E/P), the inverse of the P/E multiple.
Risk-adjustment: the outperformance survives adjustment for CAPM beta — low-P/E portfolios did not have higher betas, so the extra return is not beta compensation.
OSAP predictor: EP.
How to construct it
Sorting variable: E/P = trailing earnings per share / price (use positive-earnings firms; negative-E/P names are handled separately or excluded).
Universe: NYSE industrial common stocks in the original study (1957–1971).
Portfolio formation: annually; rank into E/P quintiles.
Long / short: long high-E/P (low P/E), short low-E/P (high P/E).
Weighting: the original used portfolio averages; modern value-weighted implementations are standard.
Rebalancing: annual.
Evidence and replication
Period
Sharpe (approx)
Notes
Source
IS (1957–1971)
meaningful
low-P/E beat high-P/E on a risk-adjusted basis
this paper
OOS (post-1977)
positive, decayed
overlaps with B/M value
post-publication
OSAP replication (EP)
clear, positive
—
Chen & Zimmermann 2022
Basu showed the low-P/E advantage was economically large and not explained by beta — a direct anomaly relative to the then-dominant CAPM.
E/P is one member of the broader value family; it is highly correlated with book-to-market (Fama-French 1992 later showed B/M subsumes much of E/P's standalone power), so it adds little once a B/M value factor is present.
The value premium generally, and E/P with it, weakened post-publication and endured a severe drawdown from ~2007–2020.
Why it might work
Mispricing / overreaction: investors extrapolate the high growth of glamour firms too far, overpaying for high-P/E names and underpaying for low-P/E names; returns correct the error. This is the Lakonishok-Shleifer-Vishny (1994) reading.
Risk-based: low-P/E firms may be distressed or carry higher fundamental risk, so the premium is compensation (the Fama-French view).
Earnings vs book anchor: E/P keys on flow (earnings) while B/M keys on stock (book equity); both proxy "cheapness," and the debate over which is the better value signal is long-running.
Limitations and risks
Redundancy with B/M: adds little incremental return once book-to-market value is in the portfolio.
Earnings definition: sensitive to negative earnings, one-off items, and accounting differences; cyclically-adjusted or forward earnings change the signal.
Value drawdowns: subject to the same multi-year underperformance risk as the broader value factor.
Crowding and decay: a long-published, widely-harvested signal.
No free full text: paywalled; see DOI.
Key references
Basu, S. (1977) — Investment Performance of Common Stocks in Relation to Their Price-Earnings Ratios — Journal of Finance — DOI: 10.1111/j.1540-6261.1977.tb01979.x
Fama, E. & French, K. (1992) — The Cross-Section of Expected Stock Returns — Journal of Finance
Lakonishok, J., Shleifer, A. & Vishny, R. (1994) — Contrarian Investment, Extrapolation, and Risk — Journal of Finance
Basu, S. (1983) — The Relationship Between Earnings Yield, Market Value and Return for NYSE Common Stocks — Journal of Financial Economics
Chen, A. & Zimmermann, T. (2022) — Open Source Cross-Sectional Asset Pricing — Critical Finance Review
