The Information Content of Price-Earnings Ratios

Abstract

T he price-earnings (P/E) ratio and dividend yield are probably the two most frequently used in the investment community. Theory and previous empirical research [5, 9, 21, 26] indicates that although a host of financial variables including risk, payout and leverage account for differences in P/E ratios of corporate equities, the principal explanatory factor is the expectation of growth in earnings and dividends. While the precise 'manner in which these expectations are formed by the market is unclear, historical growth rates, recent earnings and other corporate announcements, and market forecasts at the economy-wide and industry levels are believed to be significant. Capital market efficiency implies that all such information is fully impounded in security prices in a rapid and unbiased fashion. While an impressive body of empirical evidence supports the efficient markets hypothesis (for example, [15,20]), there does exist some evidence to the contrary [13, 14]. In particular, studies by Breen & Savage [11], Breen [10], McWilliams [22], Miller & Widmann [23] and Nicholson [25] challenge market efficiency in processing information implicit in price-earnings ratios. These studies suggest that P/E ratios may be indicators of future investment performance of securities, they have significant shortcomings that include retroactive selection bias i.e., sample being composed of only survived firms and the failure to account for risk