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Introduction
The argument of this paper is that Tobin's q ratio is useful in forecasting the price-to-earnings (PE) ratio. Knowledge about the relationship between Tobin's q and PE ratios is vital since Tobin's q and PE ratios are significantly linked to equity prices. For instance, many studies have empirically established the inverse relationship between equity returns and PE ratio. [3] Basu (1977) finds stock portfolios with a low PE ratio have higher risk-adjusted returns than the portfolios with a high PE ratio. [11] Peavy and Goodman (1983) confirm Basu's results by reporting similar findings. [5] Campbell and Shiller (1998) find that lower growth in equity price is observed following an increase in PE ratio. In addition, [7] Harney and Tower (2003) find that Tobin's q ratio is useful in explaining real rates of equity returns. Other studies have used Tobin's q as a proxy for corporate value or firm performance. Using Tobin's q as a measure of firm performance, [8] Lang and Stulz (1994) find that Tobin's q is negatively related to firm diversification. Another study using Tobin's q as a measure of corporate value shows that Tobin's q affects ownership structure ([6] Cho, 1998). [9] McConnell and Servaes (1990) find that Tobin's q (as a measure for corporate value) is positively, but diminishingly, linked to corporate ownership owned by institutional investors. [10] Morck et al. (1988) report a monotonic relationship between Tobin's q and ownership by the board of directors; Tobin's q is lower when the firm is managed by a member of the founding family, yet Tobin's q is higher when the firm is run by someone who is not related to the founding family.
Since there is a growing concern that Tobin's q and PE ratio are somewhat identical variables capturing the same phenomenon, the relationship between Tobin's q and PE ratio needs to be properly addressed. The relationship between Tobin's q and PE ratio has also been reported in the literature. First of all, a study conducted by [2] Badrinath and Kini (1994) empirically documents an inverse relationship (r =-0.644) between Tobin q and PE ratio. [1] Afza and Tahir (2012) find that dividend payout ratio and Tobin's q are key explanatory variables explaining the variability in PE ratios....