The P/E ratio is the ratio of the price of a stock to the earnings of the company. For example, if a share of a company’s stock costs $10 and over the past year the company earnings $1 per share, then the P/E ratio is $10 / $1 = 10. This is then averaged for all companies across a market or index to find the average P/E of the market. If the P/E ratio is high, then people are willing to pay more per dollar of earnings.

In value investing, there is a belief that the P/E ratio is predictive of future stock market performance. When the P/E ratio is high, stock prices are too high and will be expected to decline. When the P/E ratio is low, stock prices will be expected to rise. This assumes that the earning power of corporations drives stock valuations (which seems to be a valid assumption).

However, when looking at the relationship between P/E ratio and stock market performance (the price of the index), there is no correlation from one month to the next. In fact, there is a relatively high correlation in the same month (P is related to P/E, go figure), which isn’t very helpful. It implies that as earnings are announced, almost all investors update their price in less than a month. This result isn’t really surprising. Looking at year-to-year changes didn’t produce a better result.

It could be different for a single company, but for the index average, the earnings only result in simultaneous change, and so have no predictive power.

Forecasting refinement – P/E ratio

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