PE Ratio and Future Stock Returns

PE Ratio and Future Stock Returns

Although the PE ratio can be a very misleading indicator of future stock returns in the SHORT RUN, in the LONG RUN, the PE ratio is a very useful predictor. The reasons may be understood by analysing how stock and bond returns are calculated.

Current yield of a bond
= interest received / the price paid

This is a good measure of future return if the bond is not selling at a large premium or discount to its maturity value.

Earnings yield of a stock
= EPS / Price
= 1 / (PE)


Bonds vs Stocks

Stocks

• Since the underlying assets of a firm or stock are real, the earnings yield is a REAL, or inflation-adjusted, return.
• Over time, inflation will raise the cash flows from the underlying assets, and the assets themselves will appreciate in value.

Bonds

• In contrast, the NOMINAL return earned from fixed-income assets, where all the coupons and the final payment are fixed in money terms and do not rise with inflation.

The long-run data bear out the contention that the earnings yield is a good long-run estimate of real stock returns.

• The average PE ratio of the market over the past 130 years has been 14.45, so the average earnings yield on stocks has been 1/14.45, or 6.8%.
• This earnings yield exactly matches the 6.8% real return on equities from 1871.

Predicting Future Short-term Stock Returns using PE ratio

There are limitations to using the PE ratio to predict future short-term stock returns.

For example, future returns will be higher than predicted by the earnings yield if the economy is emerging from a recession.

And in the short run, there are many other sources of market movement, such as:

• changes in interest rates or
• the risk premium demanded by stockholders.