Long-Term Price Earning Ratio
Journal of Business Finance & Accounting, 33(7) & (8), 1063–1086, September/October 2006, 0306-686X doi: 10.1111/j.1468-5957.2006.00621.x
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
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
References: Aggarwal, R., R.P. Rao and T. Hiraki (1990), ‘Regularities in Tokyo Stock Exchange Security Returns: P/E, Size, and Seasonal Influences’, Journal of Financial Research, Vol. 13, pp. 249–63. Blackwell Publishing Ltd. 2006 1086 C 2006 The Authors Blackwell Publishing Ltd. 2006