Question

Explain how in an imperfect capital market where there is risk, that a low price-earnings ratio strategy may be able to generate excess market returns. Use relevant asset pricing models.

Answer 1

Price - earnings ratio (P/E ratio) – The price earnings ratio is the ratio obtained by dividing the market price per share by the earnings per share over a period.

Formula of PE ratio = Market price per share / Earnings per share

Investors uses price earnings ratios as a measure of how expensive or cheap a stock is for decades. The P/E shows what the market is willing to pay today for a stock based on its past or future earnings It shows whether the company's stock price is overvalued or undervalued.

For examples - A stock is trading at $40 per share with an EPS of $2 would have a P/E ratio of 20 ($40 divided by $2). However, if a stock earning $1 per share was trading at $40 per share. Then we’d have a P/E ratio of 40 instead of 20, which means the investor would be paying $40 to claim a mere $1 of earnings. This shows that the low price-earnings ratio generates excess market returns.

The biggest problem with PE ratios is the variations on earnings per share used in computing the value. The most common measure of the PE ratios divides the current price by the earnings per share in the most recent financial year; this yields the current PE.

Others prefer to compute a more updated measure of earnings per share by adding up the earnings per share in each of the last four quarter and dividing the price by this measure of earnings per share using it to compute a trailing PE ratio.

Some analysts go even further and use expected earnings per share in the next financial year in the denominator and compute a forward PE ratio. Earnings per share can also be compute before or after extraordinary items and based upon actual shares outstanding (primary) or all shares that will be outstanding if managers exercise the options that they have been granted (fully diluted). In other words, you should not be surprised to see different PE ratios reported for the same firm at the same point in time by different sources. In addition, you should be specific about your definition of a PE ratio if you decide to construct an investment strategy that revolves around its value.

Gordon Growth Model - This is one of the determinant of PE ratio. The simplest model for valuing a stock is to assume that the value of the stock is the present value of the expected future dividends. Since equity in publicly traded firms could potentially last forever, this present value can be computed fairly simply if you assume that the dividends paid by a firm will grow at a constant rate forever.

Value per share today = Expected Dividend per share next year / Cost of Equity - Expected Growth Rate

The PE ratio will increase as the expected growth rate increases; higher growth firms should have higher PE ratios, which makes intuitive sense. The PE ratio will be lower if the firm is a high-risk firm and has a high cost of equity. Finally, the PE ratio will increase as the payout ratio increases, for any given growth rate. In other words, firms that are more efficient about generating growth (by earning a higher return on equity) will trade at higher multiples of earnings.