Decomposing the Price-Earnings Ratio

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JournalJournal of Asset Management
DatePublished - 2006
Issue number6
Volume6
Number of pages14
Pages (from-to)456-469
Original languageEnglish

Abstract

The price-earnings ratio is perhaps the most widely used measure of the expected performance of companies. It has been known since 1960 that portfolios of low P/E stocks tend to outperform portfolios of high P/E stocks. Although this effect has been demonstrated by studies around the world across varying time periods, the reasons for the P/E effect remain a matter of academic debate. Until now the P/E has almost invariably been calculated as the ratio of the current share price to the previous year’s earnings, or to the current year’s consensus forecast earnings. However, the P/E of a particular stock is partly determined by outside influences such as the year in which it is measured, the size of the company, and the sector in which the company operates. Using a database amassed from the LSPD and Datastream, we examine all UK companies since 1975, and propose a modified price-earnings ratio that decomposes these influences. In particular, we find that the P/E effect that can be ascribed to a company’s sector has been working in the opposite direction to the other factors influencing the P/E, thus reducing the power of the traditional P/E to predict returns. We use a regression to weight the factors according to their power in predicting returns, and give the sector P/E effect its appropriate negative weight. The decomposed price-earnings ratio is able to double the gap in annual returns between the value and glamour deciles, and thus constitutes a useful tool for value fund managers and hedge funds

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