The Predictive Ability of P/E Ratio: Evidence from Australia and New Zealand

Abstract

We find negative relationship between historical price-earnings (P/E) ratio and following year’s stock returns in Australia and New Zealand. The existence of P/E effect is consistent with prior research in US market but the effect seems to be stronger and short-lived. Whilst the excess returns of low P/E stocks are not explained by the market risk factor, they are not significant after controlling for size, value, and momentum. We also find evidence of a positive relationship between P/E ratio and the following year’s earnings growth that suggests that investors are generally good at assessing relative earnings growth prospect of companies.

Keywords: P/E ratio, return predictability, earnings growth

JEL Classification: G11, G14