The Long-Term Price-Earnings Ratio

Keith Anderson and Chris Brooks∗

Abstract: The price-earnings effect has been thoroughly documented and is the subject of numerous academic studies. However, in existing research it has almost exclusively been calculated on the basis of the previous year’s earnings. We show that the power of the effect has until now been seriously underestimated due to taking too short-term a view of earnings. Looking at all UK companies since 1975, using the traditional P/E ratio we find the difference in average annual returns between the value and glamour deciles to be 6%. This is similar to other authors’ findings. We are able to almost double the value premium by calculating the P/E ratio using earnings averaged over the previous eight years. Keywords: price-earnings ratio, value premium, arbitrage trading rule, UK stock returns, contrarian investment

1. INTRODUCTION

The ratios of a stock’s current price to its earnings over the last company year (historical P/E) and to analysts’ consensus forecast earnings for this year (prospective P/E) are widely quoted statistics. The price-earnings effect was the earliest described asset pricing ‘anomaly’ even before the capital asset pricing model (CAPM) itself was formulated by Sharpe (1964). A large body of academic work has demonstrated the effect and has attempted to decide whether it is real or a proxy for other factors. 1 The first study demonstrating the P/E effect was by Nicholson (1960), who concluded that ‘The purchaser of common stocks may logically seek the greater productivity represented by stocks with low rather than high price-earnings ratios.’ Basu (1975) and (1977) generally confirmed Nicholson’s results. The PE effect has defied rational explanation. Ball (1978), while conceding the apparent existence of such effects, considered various possible explanations for this

* The authors are respectively from the ICMA Centre, University of Reading and Cass Business School, City University. The authors would like to thank an anonymous referee for very helpful comments on a previous version of this paper; the usual disclaimer applies. (Paper received May 2005, revised version accepted January 2006. Online publication June 2006) Address for correspondence: Chris Brooks, Faculty of Finance, Cass Business School, City University, 106 Bunhill Row, London EC1Y 8TZ, UK. e-mail: C.Brooks@city.ac.uk 1 See, for example, Nicholson (1960 and 1968), Basu (1975 and 1977), Ball (1978 and 1992), Jaffe, Keim and Westerfield (1989), Fuller, Huberts and Levinson (1993), Lakonishok et al. (1994) and Dreman (1998) to mention just US studies. C 2006 The Authors Journal compilation C 2006 Blackwell Publishing Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA.

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anomaly, including systematic experimental error, transaction and processing costs, and a failure of Sharpe’s two-parameter CAPM model. Fuller, Huberts and Levinson (1993) re-examined Ball’s (1978) argument by using a comprehensive multi-factor model that allowed for systematic risk (beta), 55 industry classification factors and 13 other explanatory factors for ‘risk’ such as earnings variability, leverage and foreign income. They again found higher returns for low P/E stocks from 1973–1990, but the factors included in the model did not account for the superior low P/E returns. Banz and Breen (1986) criticised previous studies into the size and P/E effects as suffering from two major biases: ex-post-selection bias and look-ahead bias. They eliminated these factors by amassing their own database from the COMPUSTAT tapes for 1974–81 that accurately reflected the companies in existence and the data available to investors at that time. Their conclusion was that although a company size effect...