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Not as great an impact as thought.
Does a high price-earnings ratio indicate high or low future earnings growth? Does a high P/E ratio indicate higher or lower future stock prices? We investigate the relation between P/E ratios, measuring value by closing price, and subsequent price, as well as P/E ratios and subsequent earnings yield of world markets as measured by four different indexes: the Standard & Poor's 500 (S&P 500), the Morgan Stanley Composite Index (MSCI) world index, the MSCI Europe index, and the Europe, African, and Far East (EAFE) index. Our goal is to find out whether the P/E ratios drive future earnings or drive future prices.
To evaluate the relation between P/E ratios and stock values, first we test for cointegration between P/E ratios and the yield/earnings, and between P/E ratios and price levels for each index. If no cointegration is found, we use a vector autoregression (VAR) model, and if cointegration is found, we use a vector error correction (VECM) model to study the relation between the variables. If there is any relation between P/E ratio and price level or yield on these indexes, we check for dual causality through VAR/VECM analysis using a Granger methodology. This determination could be important in explaining whether P/E ratios are useful as a valuation measure.
A number of authors have addressed the relation between P/E ratios and earnings or prices. We differentiate our study from other research by analysis of world markets besides the U.S. markets. VAR analysis has not been much used in this area either. These models will help us validate earlier results on the relation between P/E ratios and earnings.
LITERATURE REVIEW
Basu [1977] shows that portfolios formed with stocks with low P/E ratios outperform portfolios formed by stocks with high P/E ratios. Shen [2000] points out that historically very high P/E ratios have been followed by low short- and long-term returns.
Trevino and Robertson [2002] study the relation between current P/E ratios and subsequent stock returns, and find that current P/E ratios have no correlation with subsequent short-term average returns (short-term defined as three years). They further point out that investing in higher P/E ratio stocks leads to lower long-term returns for holding periods of five years or more....