The Long-Term Price-Earnings Ratio
The York Management School
University of Reading – ICMA Centre
The price-earnings effect has been thoroughly documented and widely studied around the world. 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. We look at all UK companies since 1975, and using the traditional Price-Earnings Ratio we find the difference in average annual returns between the value and glamour deciles to be 6%, similar to other authors’ findings. We are able to almost double the value premium by calculating Price-Earnings Ratios using earnings averaged over the last eight years. Averaging, however, implies equal weights for each past year. We further enhance the premium by optimising the weights of the past years of earnings in constructing the P/E ratio.
The Long-Term Price-Earnings Ratio – 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 perhaps the statistics most widely used to describe a company. That the historical P/E can be used as an indicator of future returns has been known for almost fifty years, since Nicholson (1960). Value or contrarian investment styles essentially involve purchasing stocks that are out of favour with other investors, and are employed by many large fund managers. Holding low P/E stocks as an investment strategy was also one of the main themes in Dreman (1998).
Academic studies typically find that a portfolio of “glamour” (high P/E) stocks underperforms the market as a whole by around 3%-4% a year, and a portfolio of value (low P/E) stocks outperforms it by 3%-4%. Similar results have been replicated over various time periods and in various stock markets around the world. There is an ongoing debate about the causes of this effect, which on the surface calls into question the weak-form efficiency of stock markets. Some hold it to be a reward for the extra riskiness of value shares. However, beta does not increase as the P/E decreases; if anything, it decreases (Basu (1977)), so the risk must reside in other measures. Others (Lakonishok, Schleifer and Vishny (1994)) ascribe the extra returns from value shares to psychological factors affecting market participants.
Previous research has, to the best of our knowledge, always used the same approach to calculating the E/P (the inverse of the P/E ratio): last year’s earnings, divided by the share price at the time of portfolio formation. However, there is no reason why only earnings from the previous year should be relevant in valuing companies. A year is the amount of time that the Earth takes to go round the Sun, and by law the period over which companies publish their accounts, but for many companies it has little relevance to their business cycle. We find that adding more years increases the power of the Price-Earnings Ratio to predict returns, although this does not happen monotonically. Using eight years of earnings, the difference between the returns of the glamour and value deciles is almost doubled.
The simplest way to enhance the usefulness of the Price-Earnings Ratio, which we investigate first, to assign stocks to value and glamour portfolios is to use earnings averaged over two to eight years. However, equal weights are not necessarily the best if we are tailoring the new P/E statistic to be the most efficient predictor of returns. Eight years of earnings allow an astronomical number of possible weighting systems. We investigate some obvious ones, and also calculate the predictive value of individual past years of returns.
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