The Predictive Ability of P/E Ratio: Evidence from Australia and New Zealand
- Basu and O’Shea
- A version of the paper can be found here.
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We find negative relationship between historical price-earnings (P/E) ratio and following year’s stock returns in Australia and New Zealand. The existence of P/E effect is consistent with prior research in US market but the effect seems to be stronger and short-lived. Whilst the excess returns of low P/E stocks are not explained by the market risk factor, they are not significant after controlling for size, value, and momentum. We also find evidence of a positive relationship between P/E ratio and the following year’s earnings growth that suggests that investors are generally good at assessing relative earnings growth prospect of companies.
Here is the invested growth chart for cheap and expensive. As expected, cheap wins–by a long shot!
Just how strong are the results. The details are presented in table 1:
The authors take the analysis a level deeper ala Lakonishok, Shleifer, and Vishny (1994) and look at the relation between P/E and future earnings growth.
The authors find a positive relationship and make an important point that highlights investor bias:
From these results, we infer that investors correctly assess the relative earnings growth prospects of different firms but they seem to overestimate growth potential of certain firms resulting in bidding up of their prices and subsequent disappointment leading to lower future returns.
Buying cheap down under seems like the way to go!