Question

Suppose you discovered a systematic relationship between the priceearnings ratios of stocks and the performance of stocks. In other words, knowledge of a firm’s price-earnings ratio proved helpful in predicting which stocks would show superior performance. Would this evidence be consistent with any of three versions of the efficient markets hypothesis?

Answer 1

P/E ratio indicates how much the investors are willing to pay for a stock to earn a dollar of earnings. For example if a P/E ratio of 18 means that investors are willing to pay $18 for a $1 of earnings from the stock.

Low P/E stocks have great potential for rising and earning greater returns than higher P/E ratios.

High P/E would also mean that the stock has a great potential to grow as investors view this stock positively . So, by comparing the past earnings data, we can evaluate weather the growth momentum will continue or weather this stock is simply overvalued.

So, by looking into the historical earnings , an investor can buy a low P/E stock as this stock is undervalued and has a huge potential to grow.

No, this evidence will not be consistent with any theories of the EMH. According to the EMH, by comparing the past data we cannot predict the future prices. According to the EMH , stock prices follow a random pattern. So, no fundamental or technical analysis can help predict the stock prices in the future.