What is Driving the Price-to-Earnings Ratio: The Effect of Conservative Accounting and Growth
35 Pages Posted: 25 Mar 2013
Date Written: March 25, 2013
Forward price-to-earnings ratios (PE ratios) play a central role in financial analysis and valuation. They are used to value comparable firms or to inform about mispriced stocks. We show that past investment growth and conservative accounting hinder a straightforward interpretation of the PE ratio. We analytically derive accounting-based explanations for cross sectional differences of PE ratios and analyze properties of their time series, such as volatility and mean reversion. Further, we illustrate the influence that management can take on the PE ratio by choosing accounting and investment policies. Our analysis identifies variables that drive the PE ratio and that could be used as empirical proxies to evaluate the magnitude of accounting-based influences.
Keywords: price-to-earnings ratio, unconditional conservative accounting, neutral accounting, growth, mean-reversion
JEL Classification: G11, G31, G32, M41
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