 Provide specific priceearnings and pricetosales ratios for the current market that correspond to OShaughnessys predictive deciles;
 Show the effect of the recent bear market on both ratios; and
 Show that pricetosales ratios are slightly superior to priceearnings ratios as a predictive tool. In addition, an individual investor could, with a good stock database, relatively easily update the information following the approach used here.
 Priceearnings ratios between 10 and 13 (Decile 2), and
 Pricetosales ratios between 0 and 0.34 (Decile 1).
The Predictive Power of PriceEarnings and PriceSales Ratios
by Richard Goedde
The priceearnings and pricetosales ratios are popular methods of valuing stocks. But are they really useful to an individual investor?
In his book, What Works on Wall Street (revised edition, McGrawHill 1998), James P. OShaughnessy did extensive analysis on how these ratios predict future stock price performance. He found a significant correlation between each ratio and price performance, with lower ratios leading to better performance during the following year.
This article summarizes part of his work, and provides further information on the specific priceearnings and pricetosales ratios that lead to superior results. The purpose of this article is to:
Creating Deciles
The priceearnings ratio is a stocks current price divided by earnings per share for the latest four quarters.
The pricetosales ratio is a stocks current price divided by sales per share for the latest four quarters. OShaughnessy used deciles to demonstrate the correlation between each ratio and future price performance. In this article, priceearnings and pricetosales ratios were ranked from lowest to highest, and then divided into deciles—10 groupings with an equal number of stocks.
Table 1 shows how the number of stocks per decile was determined. This table was created using the Stock Investor Pro database developed by AAII. The database includes almost all stocks (approximately 8,500) on the New York Stock Exchange, American Stock Exchange, Nasdaq National Market, and Nasdaq Small Cap Market.
TABLE 1. Defining Deciles for PriceEarnings and PriceToSales Ratios  
6/2/2000  8/2/2002  
S&P 500 Index (Close)  1477  864  
Total Stocks (No.)  9,323  8,732  
Stocks Above $150 million (No.)  4,071  3,359  
PriceEarnings Ratios  PricetoSales Ratios  
6/2/2000  8/2/2002  6/2/2000  8/2/2002  
Stocks Above $150 Mil With  
Ratios Above 0 (No.)  2,613  2,395  3,595  3,150 
Stocks Per Decile (No.)  261  240  360  315 
Source: AAII's Stock Investor/Market Guide, Inc. 
Because priceearnings and pricetosales ratios change with the market, it is useful to provide deciles at both market peaks and troughs—for this article, those are provided when the S&P 500 index was close to its peak on June 2, 2000, and 26 months later on August 2, 2002 when the index was 42% lower.
OShaughnessy chose to include only stocks with market capitalizations over $150 million (adjusted for inflation). He chose the $150 million minimum to focus on those stocks that a professional money manager could buy without running into liquidity problems. As you can see from Table 1, this reduces the number of stocks considerably.
In addition, priceearnings and pricetosales ratios equal to or less than zero are not considered to be meaningful and are eliminated. The remaining number of stocks is divided by 10 to calculate the number of stocks per decile.
On August 2, 2002, only 2,395 stocks out of 3,359 stocks (71%) with market capitalizations over $150 million had priceearnings ratios greater than zero. The remaining stocks (29%) with priceearnings ratios of zero or less are primarily due to negative earnings per share. This is compared to 3,150 out of 3,359 stocks (94%) that had a positive pricetosales ratio on August 2, 2002.
All pricetosales ratios are positive, but the Stock Investor Pro software rounded some to zero. Consequently, a meaningful (positive) pricetosales ratio can be calculated for more companies than the priceearnings ratio. Table 2 shows the priceearnings and pricesales ratio ranges for the deciles. Using priceearnings ratios on August 2, 2002 as an example, the 2,395 stocks with market capitalizations over $150 million and priceearnings ratios greater than zero were ranked from lowest to highest. They were then divided into 10 groups with about 240 stocks in each group. The lowest priceearnings ratio in Decile 1 is 0.39, while the highest for Decile 1 is 10.14—the same as the lowest in Decile 2.
Table 2 provides useful ruleofthumb information on what a reasonable priceearnings or pricetosales ratio is. For example, on August 2, 2002, the median priceearnings ratio was 18.83—the bottom of Decile 6. The median pricetosales ratio was 1.40.
TABLE 2. PriceEarnings and PriceToSales Ratios for Each Decile  
PriceEarnings Ratios  PricetoSales Ratios  
6/2/2000 (X) 
8/2/2002 (X) 
6/2/2000 (X) 
8/2/2002 (X) 

Bottom Ratio of Decile 1  1.08  0.39  0.03  0.01 
Bottom Ratio of Decile 2  8.00  10.14  0.37  0.34 
Bottom Ratio of Decile 3  10.12  12.98  0.65  0.56 
Bottom Ratio of Decile 4  12.07  14.77  1.01  0.78 
Bottom Ratio of Decile 5  14.01  16.56  1.47  1.03 
Bottom Ratio of Decile 6  16.33  18.83  2.11  1.40 
Bottom Ratio of Decile 7  20.54  21.59  2.98  1.89 
Bottom Ratio of Decile 8  28.26  25.27  4.43  2.59 
Bottom Ratio of Decile 9  41.36  32.24  8.41  3.45 
Bottom Ratio of Decile 10  75.59  50.88  21.11  5.28 
Top Ratio of Decile 10  4,025.00  2,230.00  5,140.22  712.09 
This table includes only stocks with market capitalizations greater than $150 million, and priceearnings and pricetosales ratios greater than 0. The priceearnings ratios use diluted earnings per share from continuing operations.
Source: AAII's Stock Investor/Market Guide, Inc. 
Predictive Powers
Table 2 takes on greater importance when combined with the information in Table 3, which summarizes part of OShaughnessys work. OShaughnessy started at the end of 1951 and included all stocks with market capitalizations over $150 million (adjusted for inflation). He then divided the stocks into deciles by priceearnings and pricetosales ratios—Decile 1 had the lowest ratios while Decile 10 had the highest. He then measured the average performance of all stocks in each decile during the following year—1952. This process was repeated for each year through 1996. Table 3 reports the average annual compound return for each decile over that 45year period. Note that different stocks will be in each decile each year as priceearnings and pricetosales ratios change for individual stocks over time. Note, also, that each priceearnings ratio decile will have different stocks than the pricetosales ratio decile.
Table 3 shows the superiority of pricetosales ratios over priceearnings ratios in predicting performance over the next year and over the long term (a 45year period). The pattern is perfect for the pricetosales ratios in that the average annual compound return of each succeeding decile has a lower return than the one before it.
The pattern for priceearnings ratios is also declining, but it is not as precise. More importantly, the pricetosales ratio deciles provide better predictive power between deciles as evidenced by the larger difference between the highest return—17.63% for Decile 1 pricesales ratios—and the lowest return—5.12% for Decile 10 pricesales ratios. The difference in the highest and lowest returns for the priceearnings ratio deciles is not nearly as great—16.70% for Decile 2 versus 10.34% for Decile 8.
TABLE 3. The Predictive Power of PriceEarnings and PriceToSales Ratios (Historical Period: 1/1/52 to 12/31/96) 

Decile  Average Annual Return for Following Year Based on Prior Year Ratios (%) 

Predicted by P/E Ratios 
Predicted by P/S Ratios 

1 (Lowest Ratio)  14.89  17.63 
2  16.70  16.52 
3  15.40  16.50 
4  13.60  15.64 
5  12.92  13.91 
6  11.79  13.18 
7  10.84  11.62 
8  10.34  9.93 
9  10.93  7.78 
10 (Highest Ratio)  10.98  5.12 
All Stocks  13.23  13.23 
This table includes only stocks with market capitalization greater than $150 million, adjusted for inflation over the 45year period. The priceearnings ratios use earnings per share from continuing operations. 
This table includes only stocks with market capitalization greater than $150 million, adjusted for inflation over the 45year period. The priceearnings ratios use earnings per share from continuing operations.
Stock Selection Guidelines
Having looked at the evidence in Table 3, lets look back again at Table 2, which is now interesting in another light.
With the S&P 500 index falling 42% between June 2, 2000, and August 2, 2002, one may expect priceearnings ratios to drop as stock prices fell. However, that is not always the case. While priceearnings ratios did decline for Deciles 8 to 10 (and the bottom of Decile 1), they increased for Deciles 2 to 7. This is not too surprising, given that earnings per share also dropped during this period. Of more interest is that prices did better for the stocks in Deciles 2 to 7 relative to those in Deciles 8 to 10 (implied by rising priceearnings ratios in Deciles 2 to 7), just as OShaughnessys analysis would have predicted. The high priceearnings stocks were hit the hardest during the latest bear market.
For the pricetosales ratio deciles, all deciles are lower in 2002 than in 2000. Prices fell, but unlike earnings per share, sales are more stable in a bear market. However, the high pricetosales stocks were also hardest hit, as evidenced by the larger drop in pricetosales ratios in the higher deciles.
It should be noted that pricetosales ratios vary by industry because they are affected by profit margins, which vary by industry. Supermarkets have low profit margins, which means that they need a relatively high level of sales to generate a reasonable profit, leading to low pricetosales ratios. Drug companies and jewelry stores are examples of high profit margin businesses with relatively high pricetosales ratios. Consequently, the change in pricetosales ratios between 2000 and 2002 in Table 2 is also affected by the fact that some industries, such as technology, were hit harder than others by the market decline.
Combining the information in Table 2 and Table 3 provides guidance in selecting potentially highperforming stocks. It suggests that, as of August 2, 2002, the best stocks have:
Conclusion
Both priceearnings and pricetosales ratios are significant factors in predicting future stock price performance over the next year. It is useful to have specific information on the distribution of these two ratios so that their predictive power can be realized.
Richard Goedde is an associate professor of economics at St. Olaf College in Northfield, Minnesota. He can be reached via Email at goedde@stolaf.edu.