Decomposing the Price-Earnings Ratio

20 Pages Posted: 9 Jun 2005

See all articles by Keith P. Anderson

Keith P. Anderson

The York Management School

Chris Brooks

University of Reading - ICMA Centre

Date Written: May 2005

Abstract

The price-earnings ratio is a widely used measure of the expected performance of companies, and it has almost invariably been calculated as the ratio of the current share price to the previous year's earnings. However, the P/E of a particular stock is partly determined by outside influences such as the year in which it is measured, the size of the company, and the sector in which the company operates. Examining all UK companies since 1975, we propose a modified price-earnings ratio that decomposes these influences. We then use a regression to weight the factors according to their power in predicting returns. The decomposed price-earnings ratio is able to double the gap in annual returns between the value and glamour deciles, and thus constitutes a useful tool for value fund managers and hedge funds.

Keywords: Price-earnings ratio, value investing, the value premium, trading strategy, UK stock returns

JEL Classification: G11, G12, G14

Suggested Citation

Anderson, Keith P. and Brooks, Chris, Decomposing the Price-Earnings Ratio (May 2005). Available at SSRN: https://ssrn.com/abstract=739665 or http://dx.doi.org/10.2139/ssrn.739665

Keith P. Anderson

The York Management School ( email )

York YO10 5DD
United Kingdom

Chris Brooks (Contact Author)

University of Reading - ICMA Centre ( email )

Whiteknights Park
P.O. Box 242
Reading RG6 6BA
United Kingdom
+44 118 931 82 39 (Phone)
+44 118 931 47 41 (Fax)

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