The Forward P/E Ratio and Earnings Growth
University of Massachusetts Boston
September 1, 2007
AAA 2008 Financial Accounting and Reporting Section (FARS) Paper
This paper examines the association between the price-to-forward earnings ratio (i.e., the forward P/E ratio) and subsequent realized growth. Investment practice, as well as an elementary model like the constant growth model, suggest that the forward P/E ratio depends on expected growth and risk. If investors' growth expectations are rational, a positive correlation should be observed between the forward P/E ratio and subsequent realized growth, holding risk constant. I find a nonlinear relationship between the forward P/E ratio and subsequent realized growth, whether risk is held constant or not. While firms in the highest forward P/E portfolio are most able to deliver extremely high growth, they also report losses the most frequently. My findings also suggest a U-shaped relationship between the forward P/E ratio and volatility of earnings growth. Compared to firms in the lowest forward P/E portfolio, which are inherently financially distressed, firms in the highest forward P/E portfolio are more likely to report losses and have higher volatility of earnings growth. Further analysis shows that the earnings growth of firms in the highest forward P/E portfolio is not sufficient to justify their high valuation in the base years.
Number of Pages in PDF File: 56
Keywords: Forward P/E ratio, Earnings growth
JEL Classification: G12, G14, M41working papers series
Date posted: September 13, 2007 ; Last revised: February 11, 2009
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