What Determines Price-Earnings Ratios

Topics: Spearman's rank correlation coefficient, Financial ratio, Correlation and dependence Pages: 31 (8566 words) Published: November 19, 2011
CFA Institute

What Determines Price-Earnings Ratios? Author(s): William Beaver and Dale Morse Source: Financial Analysts Journal, Vol. 34, No. 4 (Jul. - Aug., 1978), pp. 65-76 Published by: CFA Institute Stable URL: http://www.jstor.org/stable/4478160 Accessed: 12/06/2010 17:20 Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/action/showPublisher?publisherCode=cfa. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org.

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by WilliamBeaverand Dale Morse

What Price

Determines -EarningsRatios?
proach,we examinethe behavior P/E ratiosand of explore the ability of earningsgrowth (hereafter growth)and risk to explain P/E ratio differences acrossstocks.We find that,although differences in P/E ratiospersist up to 14 years,growth risk for and In appear explainlittleof this persistency. particto ular, growth appearsto have virtuallyno effect beyondtwo years.> Valuation Theory

Recent studies on the behavior of earnings growth over time raise doubt about the ability of past growth to explain differences in price-earnings ratios. Eitherfuture growth is difficultto predict, or investors are basing their predictions on information other than past growth. Grouping common stocks into portfolios on the basis of price-earnings ratios, the authors find that the initial P/E differences among the portfolios persist up to 14 years. Growthappears to explain little of the persisting P/E differences, however. Price-earnings ratios correlate negatively with earnings growth in the year of the portfolio's formation, but positively with earnings growth in the subsequent year, suggesting that investors are forecasting only short-lived earnings distortions. Nor does risk supply the explanation for these differences. Although price-earnings ratios can vary either positively or negatively with market risk, depending on the market conditions in a given year, market risk is of little assistance in explaining the observed persistence in price-earnings ratios over periods longer than two or three years. The authors conclude that the most likely explanation of the evident persistence in priceearnings ratios is not growth or risk, but differences in accounting method. >

and the Underperfectmarkets certainty, priceof a securityis equal to the presentvalue of the future cash flows. Over an infinite horizon, the current pricewill reflectthe stream dividends. of Underthe of further assumptions (1) a constantdividendpayout ratio (K), (2) constantgrowthin earningsper share(g) and (3) a constantrisklessrate(r), P/E is givenby the Gordon-Shapiro valuation equation: P/E=rKg ( (1 )

In a certainty world,earnings share(E) can be per defined as that constantcash flow whose present to value is equivalent the presentvalueof the cash flows generatedfrom current equity investment. Where the investmentinvolves assets with finite lives, this definitionimplicitlyreflectsthe...
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