DO PRICE-EARNING RATIOS DRIVE STOCK PRICES IN INDIAN STOCK MARKET?

• Author: Kanuri, Srinidhi

INTRODUCTION

Price-earnings ratio (P/E) is computed by dividing the market price of a company's stock by the company's most recent earnings per share. P/E ratio reflects how much investors are willing to pay for every dollar a company earns. Stock market investors typically use P/E ratio to identify winners and losers in the stock market. Specifically, they use P/E ratio as a tool to identify undervalued investment opportunities. But when analysts and researchers have studied the link between P/E ratio and stock returns, they have found conflicting evidence of the relation between P/E ratio and stock returns. Some investment professionals believe that a high P/E ratio indicates that the firm has growth opportunities and will translate into high future earnings.

On the other hand, other investors believe that a high P/E ratio indicates that the stock is overvalued and if the stock does not deliver expected earnings, the stock price will actually decline. Investors believe that low P/E ratio indicates undervalued stocks and are a sound investment. Despite the fact, low P/E ratio stocks did not outperform the market since 2010, nearly 80% of investors continue to use forward price-to-earnings ratio as a factor when investing, and indeed it has been cited as the number one factor for the last 14 years.

This study evaluates the relationship between P/E ratios and stock prices in India. There are several motivations for this study:

First, India is currently third largest economy in purchasing parity terms and is likely to become the world's second-largest economy by 2030, next only to China and overtaking the United States, according to the World Bank. Emerging markets (E7) could grow around twice as fast as advanced economies (G7) on average, according to Price Waterhouse Cooper (PWC). As a result, six of the seven largest economies in the world are projected to be emerging economies in 2050, led by China (1st), India (2nd), and Indonesia (4th). Since these countries represent the engine of growth for the world economy, a large amount of capital is flowing to the stock markets of these countries.

Second, India's stock market has overtaken Germany to become the seventh largest in the world. With capital flowing into the stock market of India, it is important to understand valuation fundamentals in this market. In order to better understand the stock market fundamentals in Indian stock market, we investigate whether a high P/E ratio indicates higher or lower future stock prices as indicated by Nifty 500.

Studies to understand the relationship between P/E ratios and stock prices have largely focused on developed markets. Because emerging markets have been distinguished by high returns and low covariance with global market factors, generalizing the results of developed countries on how P/E ratios impact subsequent price for emerging markets like India might be presumptuous. This study empirically analyzes the relationship between price earnings ratios and stock prices on the Indian stock market.

LITERATURE REVIEW

An economic implication of successfully predicting the relationship between P/E ratio and stock price is that the ratio will allow an astute investor to successfully time the market. Several studies have aimed to understand this issue.

McWilliams (1969), Basu (1977), and Goodman and Peavy (1983) found that low P/E ratio stocks generally outperform high P/E ratio stocks. Goodman and Peavy (1983) also found that as P/E ratio increases, returns decline consistently. Keown, Pinkerton, and Chen (1987) studied portfolios of stocks made up of either low or high P/E ratios and concluded that investors who practice a P/E based investment strategy expose themselves to very high levels of unsystematic risk.

Campbell and Shiller, who have extensively researched P/E ratios since the mid-1980s, concluded that generally P/E ratios are powerful predictors of long-term stock returns but P/E ratios and dividend price ratios are also poor predictors of future dividend growth, future earnings growth, or prices (1988, 1989), and stocks with high P/E ratios are likely to have their stock prices drop significantly in the future (1998, 2001).

Campbell and Shiller (1998) also analyzed historical data for the mean reversion property among the P/E ratios and found that higher P/E ratios are followed by lower growth. Kane Marcus, and Noh (1996) found that P/E ratios are highly sensitive to volatility, indicating that any study that ignores the impact of volatility on equilibrium P/E is inherently perilous.

Park (2000), on the other hand, advised that an investor should not take a high P/E ratio by itself as an alarming sign and that the P/E ratio is of limited use as a measure of stock valuation. He found that P/E ratio is explained well by future earnings and interest rates, and stock markets foresee a fairly distant future of about eight years. Fisher and Statman (2000) investigated the relationship between P/E ratios and dividend yields and future returns and concluded that P/E ratios and dividend yields are not good indicators of future stock prices, especially in the short-horizon (one to two years). P/E ratios and dividend yields provide as much stronger forecasts when used to estimate stock returns over a longer horizon (ten years).

Trevino and Robertson (2002) found while that current P/E levels correlate poorly with short term (less than three years) average returns, long term (holding periods more than five years) average returns are lower when P/E ratios are high. Further, they concluded that even though long-term average stock returns are lower after periods of high P/E ratios, average stock returns are still higher than average returns on Treasury bonds and Treasury bills.

More recently, Bhargava and Malhotra (2006) noted that as a P/E ratio goes up, subsequent stock prices increase, and subsequent yields decline...