Investment Performance of Common Stocks in Relation to Their Price‐earnings Ratios: A Test of the Efficient Market Hypothesis

Abstract

I. INTRODUCTIONIN AN EFFICIENT CAPITAL MARKET, security prices fully reflect available information in a rapid and unbiased fashion and thus provide unbiased estimates of the underlying values. While there is substantial empirical evidence supporting the efficient market hypothesis,' many still question its validity. One such group believes that price-earnings (P/E) ratios are indicators of the future investment performance of a security. Proponents of this price-ratio hypothesis claim that low P/E securities will tend to outperform high P/E stocks.2 In short, prices of securities are biased, and the P/E ratio is an indicator of this bias.3 A finding that returns on stocks with low P/E ratios tends to be larger than warranted by the underlying risks, even after adjusting for any additional search and transactions costs, and differential taxes, would be inconsistent with the efficient market hypothesis.4 particularly to this Journal's referees, Nancy L. Jacob and Marshall E. Blume, for their very helpful comments and suggestions. Of course, any remaining errors are the author's responsibility. Research support from the Graduate School of Business and Public Administration, Cornell University is gratefully acknowledged.1. See Fama [8] for an extensive discussion of the efficient market hypothesis and a synthesis of much of the empirical evidence on this issue.2. See Williamson [28; p. 1621. Smidt [27] argues that one potential source of market inefficiency is inappropriate market responses to information. Inappropriate responses to information implicit in P/E ratios are believed to be caused by exaggerated investor expectations regarding growth in earnings and dividends; i.e., exaggerated optimism leads, on average, to high P/E securities and exaggerated pessimism leads, on average, to stocks with low P/E ratios. For an elaboration on this point see [19; p. 28], [20], [21] and [28; p. 161-1621. A contrary position is discussed in [22]. 4. In general, results of previous empirical research by Breen [5], Breen & Savage [6], McWilliams [18], Miller & Widmann [19] and Nicholson[20] seem to support the price-ratio hypothesis. While this may suggest a violation of the semi-strong form of the efficient market hypothesis, all of these studies have one or more of the following limitations: (i) retroactive selection bias, (ii) no adjustment for risk, marginal information processing and transactions costs, and differential tax effects pertaining to capital gains and dividends, and (iii) earnings information is assumed to be available on or before the reporting date. 664The Journal of Finance II. DATA AND METHODOLOGYThe following general research design was employed to examine the relationship between P/E ratios and investment performance of equity securities. For any given period under consideration, two or more portfolios consisting of securities with similar P/E ratios are formed. The risk-return relationships of these portfolios are compared and their performance is then evaluated in terms of pre-specified measures. Finally...

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Firm Characteristics and Stock Returns: The Role of Investment-Specific Shocks

“…Our work provides a unified explanation for several empirical patterns extensively documented in the literature, including the relation between average returns and: price-earnings ratios (Rosenberg, Reid, and Lanstein, 1985;Basu, 1977;Haugen and Baker, 1996); market-to-book ratios and Tobin's Q (Fama and French, 1992;Lakonishok, Shleifer, and Vishny, 1994); investment rates (Titman, Wei, and Xie, 2004;Anderson and Garcia-Feijo, 2006); profitability (Fama and French, 2006;Novy-Marx, 2012); idiosyncratic return volatility Zhang, 2006, 2009); as well as the fact that the security market line is weakly downward sloping (Black, Jensen, and Scholes, 1972;Frazzini and Pedersen, 2010;Baker, Bradley, and Wurgler, 2011;Hong and Sraer, 2012).…”

Signalling the Dotcom bubble: A multiple changes in persistence approach

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