Decomposing the Price-Earnings Ratio

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