The Forward P/E Ratio and Earnings Growth
47 Pages Posted: 13 Sep 2007 Last revised: 21 Aug 2013
Date Written: August 15, 2013
Valuation theories predict a negative relation between the earnings-to-price (E/P) ratio and future earnings growth, but prior studies have produced conflicting results. Using a growth measure that incorporates loss firms, this paper shows that the negative relation exists in the long term, but not in the short term. Contrary to theoretical predictions, the results show a U-shaped relation between the forward E/P ratio and earnings risk. Compared with firms in the highest forward E/P portfolio which are inherently financially distressed, firms in the lowest forward E/P portfolio exhibit even higher incidence of loss and larger growth volatility in subsequent years. A supplementary analysis reveals a wide distribution of earnings growth in the lowest forward E/P portfolio: this portfolio includes not only star firms that generate the strongest earnings growth but also firms that report the most negative earnings growth. This paper shows that the forward E/P ratio is a stronger predictor of future growth than the conventionally used trailing E/P ratio.
Keywords: E/P Ratio, Forward E/P Ratio, Earnings Growth, Risk
JEL Classification: G12, G14, M41
Suggested Citation: Suggested Citation