How Important is the P/E Ratio in Determining Market Returns?

Abstract

This analysis assesses the actual contribution of the P/E ratio to realized compound market returns for various time periods. Using a supply-side model, we can accurately measure the contribution of the P/E ratio to average market returns. A clear understanding of this relationship allows investors to concentrate on those determinants of the long-run average market return that will, typically, have the most important impact on the market's performance. The results demonstrate that over very long periods of time the P/E ratio typically contributes little or nothing to the average market return. However, there are exceptions, particularly for shorter time periods.