When Do PE Ratios Matter?

Abstract

This article explores why it is generally difficult to use price-to-earnings (PE) ratios in investment strategies and how PE ratios can be used in investment strategies. The basic insight is that when observed PE ratios are higher than predicted PE ratios, analysts’ earnings forecasts tend to increase over time and that when observed PE ratios are lower than predicted, analysts’ earnings forecasts tend to decrease over time. Therefore, what appears to be an expensive market with a high PE ratio based on analysts’ lower earnings forecasts may actually be a market that has higher expected earnings and thus is more reasonably priced. Likewise, what appears to be a cheap market with a low PE ratio based on analysts’ higher earnings forecasts may actually be a market that has lower expected earnings and is thus less attractively priced. As a result, the simple expectation that high observed PE ratios will result in lower future returns and that low observed PE ratios will result in higher future returns is often premature. When conditioned on the expected change in analysts’ earnings forecasts, however, PE ratios can be used to forecast market returns. Although the results are strongest in developed markets, they also hold in the major emerging market countries.