Price-Earnings (PE) ratio is a very powerful indicator in accessing share performance against its competitors or industry players. This study focuses on constructing portfolios on the basis of PE ratio and measuring its performance against the benchmark BSE sensex for the last 10 years (2002-2012). BSE index is above 24000+ points and picking stocks at this level is a risky business. Most of the investors and fund managers believe in picking stocks which are relatively cheaper than the industry average and therefore PE ratio would play an important role. Using a combination of statistical tools, it is proved that portfolios formed on the basis of low PE outperform the BSE Benchmark market returns.

In recent years, the Price-Earnings (P/E) ratio has become the most popular approach for equity valuation. To obtain a fair valuation of corporate stocks, P/E ratio of the company is multiplied by its expected future earnings. Thus, P/E ratio indicates the average price the market is willing to pay for purchasing each unit of company earnings and therefore, it should reflect the earnings quality and industry growth potential.

A lot can be said about the ratio, but a general remark that is made about this ratio is that if a company is growing and has a higher earning potential, then the P/E ratio will also be high. P/E ratio is considered as a proxy to the firm’s growth rate.

Sharpe (1966) introduced a risk-adjusted measure of determining the portfolio performance referred to as the Sharpe ratio or Reward-to-Variability Ratio (RVAR). Sharpe used RVAR for the following:

• To measure the risk premium, that is, the excess return required by investors, relative to the total amount of risk in the portfolio.
• Rank portfolios’ performance using the RVAR.

Sharpe returns of a portfolio are compared with the market returns, and thereby, a selection criterion for constructing an optimum portfolio (i.e., portfolio that outperforms market) on the basis of fundamental variables is identified. This helps the investors to achieve their objective of maximizing returns for a specified acceptable level of risk.

Applied Finance Journal, Testing, Efficiency, Price-Earnings Ratio, Constructing Portfolio, Price-Earnings (PE), Compounded Average Growth Rate (CAGR).