Vorek Marin

8/6/2019 Vorek Marin

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Abstract

This paper examines the strategy of value investing and its further possibilities for predictionof stock performance, especially in connection with falls in stock prices. The methodologyused is based on the implications of the theory of financial markets and the methodology of fundamental analysis. The value investments analysis prepare estimates of a common stocksintrinsic value by multiplying the respective multiplier (e.g. P/E, P/S, P/CF, P/BV) times therespective actual quantity of stocks earnings, sales, cash flow, book value, etc. Price toearnings ratio is one of the most used and frequently discussed. The price earnings ratio andits dynamics are determined by current stock price and by earnings per share. Having testedhistoric yields of stocks in relation with their level of price earnings ratio, the analysts havediscovered that there is a negative correlation between the stocks yield and its level of priceearnings ratio. Consequently, the above outcome has been further developed into a strategycalled the strategy of low price to earnings ratio. This strategy was subject to the further research of which results have doubted the efficient market theory. The research discoveredthat the investments into stocks with low price to earnings ratio achieved higher than averagereturns. Based on the above mentioned methodology and the outcomes of empirical studies,this paper focuses on the other side of that relation, whether the high price to earning ratio

predicts the future falls in stock prices and whether the price to earnings ratio could act as anindicator of the coming bear market.

Key words: price to earings ratio, P/E, low P/E, high P/E, stocks performance, value investing


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Preface

Hopefully, global economy is through or at least close to the end of, recession, which wastriggered by U.S. sub-prime mortgage sector in 2007. It seems that almost every worldeconomies were affected by this recession. The university researchers and market analystssearch for its causes. Some of them say that the primary causes have arisen from the cheapmoney policy supported by low interest rates; the other seek it in risk evaluation of derivatives and securitization of assets. The buyers of such derivatives are not able to estimatethe corresponding risk level.

Nevertheless, recessions are unfavorable part of economy as it develops in cycles. Despite thefact that recessions are being sensed negatively, their presence lead the particular marketsubjects to more efficient behavior, which contributes to better efficiency of the wholesystem.

This cannot stop scientists who still try to explain how to predict the crisis periods and to findindicators that might predict the crises.


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Introduction

Financial crises result in destructive impacts on respective economies (recessions) and deepdownfalls of financial markets. Therefore, several authors aim to address the questionsregarding factors that cause the crises, ways how to solve them or how to precede them.Researchers concentrate effort to create a conventional model that would propose anexplanation and could simulate an economic environment prior to and during the crisis.However, there is yet no general theory that would be able to answer all the questions.Therefore, none of proposed approaches has been accepted yet. This unfavorable outcomemay have its roots in very broad foundation, where particular crises may arise from.

These considerations end up in other questions whether the crises may even be predicted andwhether there are exact indicators/parameters that may detect the thread of these unfavorablemarket conditions.

The financial markets usually anticipate recessions, and thus the first negatively affected.However, some of the financial market turmoils are being triggered without any rationalcauses and are being driven just by herd behavior of market players.

The bearish markets could be characterized with a loss of confidence in market valuation of securities. Hence, all subjects focus on closing of their risk positions and minimal losseswhich triggers the sale wave resulting in deep fall of security prices. Subsequently, volatilityof security prices raises as a result of unsteady foundation in security valuation models.

The market researchers and analysts seem to be able forecast the key economic drivers by

application of some growth rate during the time of economic growth. However, none of themhas ever projected coming declines in advance.

This paper points to the well known investment strategies based on value investing theory andits multiples; and searches for its potential reverse application in indicating the financialmarkets fall in advance.


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Theoretical Foundation

Value investing is an investment theory that derives from the ideas of Ben Graham and DavidDodd formed in their text Security Analysis (1934). The main idea involves buying securitieswhose shares appear underpriced by some of its fundaments1. Such securities might be tradedat discounts of book value, sales or earnings multiples. The essence of value investing is buying stocks at less than their intrinsic value, where intrinsic value is the discounted value of all future distributions.

This approach has evolved significantly since 1970s. The most successful Grahams student isWarrant Buffet, who runs Berkshire Hathaway.

One of the investments strategies is derived from undervalued basic fundaments which areexpected to determine the stock price. This is typical for stocks traded with discount and atlow multiples of sales (Price to Sales), book value (Price to Book Value), earnings (PriceEarnings) and cash flow (Price Cash Flow). From long term prospective, the investmentstrategies based on the investments into stocks with low multiples result in comparably higher annual return. Success of these strategies is illustrated on picture below.

Picture 1 Annual return of the strategies based on the multiples

Source: www.dreman.com

1 Graham, Benjamin (1934). Security Analysis New York: McGraw Hill Book Co., 4


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Data showed on picture 2 demonstrate the recent development of P/BV, P/E and P/S multiplesof indices S&P 500 and PX (index of Prague Stock Exchange) during the current crisis(March 2005 to March 2009). The pictures prove that the multiples are not stable and mightindicate economic environment.

Picture 2 Development of trading multiples of S&P 500 index and PX index (March 2005 March 2009)

Source: Bloomberg

There was a decline in trading multiples of S&P 500 and PX prior to the current crisis.

The multiples of S&P 500 peaked in summer 2007, when stocks were traded at 3 times

multiple of book value, which means that investors valued the company 3 times higher thanits accounting value of the equity. Price earnings and sales multiples amounted to 17, 1.6respectively. Then, in September the trading multiple fell down to 1.8 for book valuemultiple, 12 for price earnings ratio and 0.6 for sales multiple.

The multiples of Czech stock market index PX has developed very similarly to S&P 500.However, the volatility of index PX has been higher and the index peaked earlier at the beginning of 2007.

Picture 2 might also illustrate the fact that investors were willing to invest at higher tradingmultiple in the period prior to crisis. While during the crisis the trading multiples bottomeddown.


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Further in the theory section, the text is focused on one particular measure which is based onratio of stock price (P) and earnings per share (EPS or E). Price to earnings is an indicator which indicates current mood of investors how much they are willing to pay per unit of company earnings.

The stock price and the earnings per share determine the value of the ratio. P/E increaseswhen investors are willing to pay more per unit of earnings while the earnings remain stable.P/E also grows when both the stock price and the earnings per share increase, however, theincrease of stock price must be sharper than the increase in the earnings per share. Another scenario of increasing P/E take place, when stock price remain stable despite there is adecrease in the earnings per share. The price earnings ratio does not change when there is a balance between the growth of the stock price and the earnings per share.

On contrary, P/E declines when the willingness of investors to pay price per unit falls as wellas when the price paid per stock by investors increases in slower pace than the earnings per share, etc.

Exhibit 1Analysis of movements of price earnings ratio

Priceearnings

Price Earnings per share

Action

Price earnings ratio increases due to higher price, whileearnings (EPS) remain stable.Investors pay higher price per unit of company earnings.

Stock price grows in higher pace than company earnings.Subsequently, this leads to higher P/E.Investors react on growth of company earnings. Investorsmay have high expectations of future growth or overvaluedthe current growth of company earnings.

Despite a decrease in company earnings the stock priceremains stable.Investors do not react on the decrease of company earnings.

Stock price decreases in slower pace than companyearnings.Investors have not reflected full impact of company earningsdecrease into stock price.

Stock price increases despite the decrease of companyearnings.Investors do not reflect decrease of company earnings instock price.


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This very brief attempt points to the fact that the P/E growth might symbolize misbalance between the growth of stock price and growth of company earnings, which might be caused by different expectations of company future.

Furthermore, the main specifics of the ratio are derived from profit models and are based onthe following equation:

P = E / k + R

where P stands for stock price,E earnings per share,k discount rate andR is net present value of future growth opportunities2.

Based on the preceding formula, P/E ratio might be reformulated as:

P/E = 1 / k + R / E.

This equation determines further the key drivers of the P/E ratio. On one hand, P/E is

positively driven by the future growth opportunities, as already suspected, and negatively bydemanded rate of return in denominator set as discount rate.3

Thus, one can expect that the companies with high growth opportunities such as IT/IS stocksin 1990s would have high P/E ratios while the P/E of companies with limited growthopportunities such as railroad companies, food chains, airlines, etc. would be dramaticallylower 4.

The low level of P/E might be also explained as a so called effect of neglected companies or effect of small companies. The size of the business is too small, that the analysts do not payenough attention to analyze it or analyzing it would not be efficient. In many cases, the smallcompanies do not dispose information that would allow reasonable analysis. Nevertheless,this should not be valid for market indices.

2Ross, Westerfield, Jaffe: Corporate Finance, page 1213 Muslek, P.: Financial markets and investment banking, page 264

4 This might also explain so called burst of technological stocks in 2001.


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The second parameter that influences P/E is the discount factor that is related to currentinterest rate. Hence, it is the current interest rate and its fluctuation which might contribute tovolatility of P/E.

Due to simplicity of P/E ratio, authors, researchers and investment public form various typesof it. Differences amongst them arise from time coincidence between the earnings per shareand current price, resp. substituted by intrinsic value of the stock. Other approach thatdifferentiates this ratio and is derived from intrinsic value calculation uses different earnings.These might be either current earnings or expected earnings. The expected might becalculated from a formula that is based on the last published earnings and one from thefollowing: earnings growth rate, management expectations or estimates of analysts.

The following constructions of P/E are well known:

The most simple and also most exploited iscurrent price earnings ratio . This approach formsa ratio of current stock price and last posted earnings per share. This P/E works as a benchmark for other constructions of P/E. Thus, it is a basic measure for P/E based onintrinsic value and statistical methods derived from regression analysis. Due to its simplicity,

the outcomes of this calculation are presented in stock recommendations, stock analysis, stock lists, etc.

Normal P/E 5 is based on Gordon dividend model transformed into profit model6. One of theunderlying assumptions says that a part of company profit (earnings) is retained (b) and a partis paid out as a dividend (p). The (b) + (p) must equal to 1.

IV 0 = D 1 / (k-g) IV 0 = E 1 * p / (k-g)

P 0 / E 1 = p / (k-g) 7

Where IV0 intrinsic stock valuek demanded rate of return

5Cipra Tom, Mathematics of securities, page 1186 Dividend discount model with constant growth

7 Vesel Jitka, Securities analysis, part II, page 188 - 198


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E1 expect earnings in time period t+1D1 dividend in time period t+1g dividend growth rate p dividend pay-out ratio

V 0 = (P/E) N * E 1

Where (P/E) N equals to P0 / E1.And dividend D1 is defined in time period t+1 as:

D1 = p * E 1

Further transformation of the formula leads to the determinants of current P/E. These areearnings growth rate, demanded rate of return, and dividend pay-out ratio. The impact of thefirst two was described in the above text. The impact of dividend pay-out ratio depends on arelation between ROE and demanded rate of return. Should ROE exceed demanded rate of return, then increase of dividend pay-out growth leads to lower P/E. Contrary, should ROE belower than demanded rate of return, then an increase of dividend pay-out ratio results inhigher P/E.

Other type of P/E ratio isSharps P/E , which arises from expected earnings instead of currentearnings.

IV0 / E0 = p* (1+g) / (k-g)

Where IV0 stock intrinsic valueE0 current earningsk demanded rate of returng earnings growth rate p dividend pay-out ratio

In case that earnings growth rate does not equal to zero, the Normal P/E and Sharps P/E8 differ just by a variance caused by the earnings growth.

8 http://www.stanford.edu/~wfsharpe/


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The difference between Sharps and current P/E serves as an indicator, whether current stock price is undervalued or overvalued compared to its intrinsic value represented by Sharps P/E.The higher Sharps P/E indicates that the stock price is undervalued and contrary.

Historic P/E is different approach calculated as an average of historic P/Es. Assumed is, thatP/E moves in a range around its long-term average. A difference between the current P/E andthe historic average symbolizes whether current stock price is priced correctly.

Other construction of P/E is represented byregression P/E , which is calculated on the basis of regression formula that simulates changes of P/E based on its parameters. The parameters arederived from historic values of P/E and its key drivers. Once the formula is filed out withinput data, it results in regression P/E.

P/E = + *g + *p + * ,

Where , , , regression coefficients,g... earnings growth rate, p... dividend pay-out ratio,

... risk rate.

Also regression P/E might be exploited for an analysis whether the current stock price isundervalued or overvalued.

The last approach is known as P/E of comparable companies . This formulation of P/Ecompares the current P/E of one particular company with other peer companies of comparable parameters and similar business conditions.

The practical investment strategies are based on the picking of stocks with low P/E or findingthe intrinsic value of the company and comparing that with the current parameters. Thesestrategies are being connected with so called low P/E effect or low P/E anomaly.

The historic verification of the low P/E strategy has confirmed existence of low P/E anomalywhich assures higher than average returns9.

9 S. Basu: The Investment Performance of Common Stock in Relation to their Price-Earnings: A Test of the


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Dreman verified the low P/E strategy on a sample of historic data consisting of 1,250 stocksin the period between 1968 and 1977. Outcomes of his study are summarized in a table below.

Exhibit 2Annualized returns of portfolios (Dreman study)

Portfolio 3M 6M 12M 36M 108M1. Highest P/E -2.64% -1.06% -1.13% -1.43% 0.33%2. 0.92% 1.62% 0.56% -0.28% 1.27%3. 0.51% 0.62% 1.63% 0.85% 3.30%4. 3.06% 3.42% 3.31% 4.87% 5.36%5. 2.19% 4.46% 2.93% 5.02% 3.72%6. 4.84% 5.33% 6.70% 4.82% 4.52%7. 7.90% 6.07% 6.85% 5.89% 6.08%8. 8.83% 8.24% 8.56% 7.78% 6.35%9. 11.85% 8.40% 6.08% 7.73% 6.40%

10. Lowest P/E 14.00% 11.68% 10.26% 10.89% 7.89% Source: G. Smith: Investments, Scott and Foresman Company, 1990, p. 370

Steven Bleiberg verification research based on the data between 1938 and 1989 has resultedin similar outcomes, which are summarized in table below.

Exhibit 3Annualized returns (%) in Bleiberg study

Fifth by P/E level % of observations 6M 12M 24M1. 40 1.55% 2.73% 0.41%2. 13 1.99% 4.87% 7.52%3. 15 -1.32% -2.15% 5.35%4. 11 -2.06% -0.41% 3.08%5. 21 6.59% 12.37% 20.95%Total 100 1.54% 3.98% 7.01%

Source: S. Lofthouse: Equity Investment Management, 1994, page 249

The confirmation of the existence of low P/E anomaly in stock markets denies the effectivecapital market theory as described by E. Fama in 197010.

Efficient Market hypothesis, Journal of Finance no. 32, 1977,D. A. Goodman, J. W. Peavy: Industry Relative Price-Earnings Ratios as Indicators of Investment Returns,Financial Analysts Journal no. 39, 1983D. Dreman: The New Contrarian Investment Strategy, New York, Random House, 1982S. Bleiberg: How little we know about P/Es, but also perhaps more than we think, Journal of PortfolioManagement no. 15, summer 1989, page 26 3110 E. Fama: Efficient Capital Markets: A Review of Theory and Empirical Work, Journal of Finance, 25, p. 383-417, 1970


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Empirical Observations

Based on the empirical data, the price earnings ratio might have been used for a constructionof successful investment strategies.

Could be this approach reverted and could it also work as an indicator for predicting of futurestock market lows? Could high levels of P/E ratio predict future falls of stock markets?

The chart below shows the development of S&P 500 index and its P/E between 1964 and2009. In this period, there were four significant downturns of financial markets. The first isrelated to oil shocks in early 70s; the second happened in 1987, when the stock marketssuddenly dropped; and next two falls were seen in 2001 and 2007 which were connected to a burst of dotcom bubble and to the U.S. subprime mortgage crisis, respectively.

Exhibit 4Development of S&P500 index and its price earnings between 1964 and 2009

0

200

400

600

800

1000

1200

1400

1600

1800

2 9

. 1 . 1

9 5

4

2 9

. 1 . 1

9 5

7

2 9

. 1 . 1

9 6

0

2 9

. 1 . 1

9 6

3

2 9

. 1 . 1

9 6

6

2 9

. 1 . 1

9 6

9

2 9

. 1 . 1

9 7

2

2 9

. 1 . 1

9 7

5

2 9

. 1 . 1

9 7

8

2 9

. 1 . 1

9 8

1

2 9

. 1 . 1

9 8

4

2 9

. 1 . 1

9 8

7

2 9

. 1 . 1

9 9

0

2 9

. 1 . 1

9 9

3

2 9

. 1 . 1

9 9

6

2 9

. 1 . 1

9 9

9

2 9

. 1 . 2

0 0

2

2 9

. 1 . 2

0 0

5

2 9

. 1 . 2

0 0

8

5.00

10.00

15.00

20.00

25.00

30.00S&P 500

P/E

AVG P/E

Source: Bloomberg

The exhibit also illustrates that the P/E is very volatile indicator that historically fluctuatedaround its long term average. In different periods, the level of P/E differed and experienced both the sharp growths and sudden declines. Especially in the crisis periods, the P/E dropped


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Exhibit 5Annualized return of S&P 500 with investment horizon 1year and 5 years respectively (1967 2008)

-60.00%

-30.00%

0.00%

30.00%

60.00%

5.00 10.00 15.00 20.00 25.00 30.00 35.00

P/E

A n n u a

l i z e

d R e

t u r n

( I n v e s

t m e n

t H o r i z o n

1 Y )

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

5.00 15.00 25.00 35.00

P/E

A n u a

l i z e

d R e

t u r n

I n v e s

t m e n

t H o r i z o n

5 Y

Regression formula y = 0.174 0.006 * P/E Regression formula y = 0.139 0.004 * P/ER square 0.039 R square 0.318Standard deviation 0.164 Standard deviation 0.070 No. of observations 10,380 No. of observations 9,398

Source: own calculations, Bloomberg

Exhibit 6Annualized return of PX with investment horizon 1year and 5 years respectively (1967 2008)

-80%

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

5 10 15 20 25 30 35 40 45

P/E

A n n u a

l i z e

d R e

t u r n

I n v e s

t m e n

t H o r i z o n

1 Y

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

35%

40%

5 15 25 35

P/E

A n n u a

l i z e

d R e

t u r n

I n v e s

t m e n

t H o r i z o n

5 Y

Regression formula y = -0.014 0.011 * P/E Regression formula y = 0.531 0.018 * P/ER square 0.052 R square 0.895Standard deviation 0.290 Standard deviation 0.034 No. of observations 1,831 No. of observations 826

Source: own calculations, Bloomberg


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The following charts highlight the relation between future annual return of S&P 500 indexand its P/E in periods prior the respective crisis and in periods during these crises.

Exhibit 7Annualized return of S&P500 with investment horizon 5 years respectively (1967 2008)

1972 1973-1974

-6.00%

-5.00%

-4.00%

-3.00%

-2.00%

-1.00%

0.00%

1.00%

10. 00 15. 00 20. 00 25. 00 30. 00

P/E

A n n u a

l i z e

d R e

t u r n

I n v e s

t m e n

t H o r i z o n

1 Y

-8.00%

-6.00%

-4.00%-2.00%

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

5.00 10.00 15.00 20.00 25.00

P/E

1986-1987 1987-1989

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

5.00 10.00 15.00 20.00 25.00

P/E

A n u a

l i z o v a n

v

n o s

i n d e x u

S & P 5 0 0

v h o r i z o n

t u 5

l e t

0%

2%

4%

6%

8%

10%

12%

14%

5. 00 10. 00 15. 00 20. 00 25. 00

P/E

A n u a

l i z o v a n

v

n o s

i n d e x u

S & P 5 0 0 v

h o r i z o n

t u

5 l e t

1999-2000 2000-2002

-6%

-5%

-4%

-3%

-2%

-1%

0%

5.00 10.00 15.00 20.00 25.00 30.00 35.00

P/E

-10.00%

-5.00%

0.00%

5.00%

10.00%

15.00%

5.00 10.00 15.00 20.00 25.00 30.00 35.00

P/E


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The take-aways from the exhibit are not unique for each crisis. In period prior to oil shock crisis in 1972, the level of P/E amounted to approx. 20. During the crisis the P/E level felldown to 7 8. In the example of 1987 stock price fall, P/E rose sharply from 12 to 22 in preceding year. The sudden fall of stock prices returned the P/E back to 10.

In the 90s, the stock prices boomed. Analysts interpreted the stock price boom with newinformation technologies. Even in short time prior the burst of that bubble, analystscommented on this matter and argued with new IC/IT technology that justifies the high levelof P/E. P/E reached its maximum of 30. The bubble burst in 2001 and the P/E ratio fell to 15.

Exhibit 8Development of price earnings ratio during the selected crisis

Oils shocks 1987

Dotcom bubble U.S. subprime mortgage

Source: Own calculations, Bloomberg


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The level of P/E ratio in period preceding the current crisis amounted to 17, which wascomparably less than the level in 2001. The subsequent stock market turmoil, whichanticipated the world recession, pushed it down to 11.

The historic values of P/E and its development in decades between 1954 and 2009 are shownin exhibit 8.

Before stock market fall in 1987 and before the burst of dotcom bubble in 20000, the level of P/E exceeded significantly its long term average. Especially during 90s, price earnings ratio jumped beyond 30. However, subsequent downturn backed the multiple to the level of longterm average around 16.

Similar observations are shown in exhibit 9, which illustrates development of P/E arithmeticmean of S&P500 in particular year. The chart is constructed for a 5 years prior and 5 yearsafter the year of the stock market fall. This might disclose whether, price earnings ratio might be used as an indicator for prediction of future stock market falls.

Exhibit 9Annual return of S&P500 and its average price earnings ratio

1968 1978

8.1%

12.0%16.1%

28.4%

18.2%

2.4%-11.1%-29.8%-18.1%-11.4 % -0 .9 %

-30.0%

-20.0%

-10.0%

0.0%

10.0%

20.0%

30.0%

1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978

17.58 16.84 14.89 18.64 18.96 16.28 10.23 10.00 12.34 9.93 8.82 P/E

P/E 1968 - 1978

P/E 1954 - 2009 16.46

14.01


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1982 - 1992

1995 - 2005

2002 2009

Source: Own calculations, Bloomberg

14.6%

27.8%

15.5%

28.4%

4.4%-8.2%2.0%

19.2%

0.3%

8.5% 27.8%

-30.0%

-20.0%

-10.0%

0.0%

10.0%

20.0%

30.0%

1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992

8.01 1 2.51 11 .0 2 11.3 0 15 .89 19 .27 14 .10 13 .3 0 1 5.1718.53

P/E

P/E 1982 - 1992

P/E 1954 - 2009 16.46

14.90

34.2%

26.1%19.6%

3.8%-23.8%

9.3%

-10.5%-9.3%

19.3%

31.7%

22.3%

-40.0%

-30.0%

-20.0%

-10.0%

0.0%

10.0%

20.0%

30.0%

40.0%

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

16.58 19.20 22.33 25.30 28.88 27.26 22.96 22.27 19.16 18.92 17.46 P/E

P/E 1995 - 2005

P/E 1954 - 2009 16.46

21.87

-23.8%

3.8%

11.8%9.3%

22.3%

3.7%-37.6% -11 .2%

-40.0%

-30.0%

-20.0%

-10.0%

0.0%

10.0%

20.0%

30.0%

40.0%

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

22.27 19.16 18.92 17.46 16.57 16.75 15.63 11.39 P/E

P/E 2002 - 2009

P/E 1954 - 2009 16.46

17.87


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Stock market fall in 1973 was not preceded by price earnings ratio higher than 30. However,P/E exceeded its average in each of those 5 years prior to 1973. Price earnings ratio after thecrisis decreased by half compared to its level before the stock market turmoil.

Interpretation of the stock market decline from 1987 might be different. It seems like it was just one-off correction that resulted in decline of P/E which has been above average onlyduring the year 1987. Nevertheless, the S&P500 ended with positive annual return in thatyear. At the beginning of 80s, P/E level was relatively low. Subsequently, the values of priceearnings ratio grew from 8 to 18.

Burst of the so called dotcom bubble in 2000 was in line with assumed scenario. Since 1995on, the P/E ratio grew from 16 to more than 28. After the burst in 2000, the P/E returned to itslong term average. Compared to 70s, the decrease was rather gradual.

The last picture of exhibit 9 shows the current economic crisis development in terms of P/Edevelopment and stock prices behavior. The intensity of the fall of price earnings ratio is fullycomparable with 70s. Contrary to 70s, the level of price earnings ratio did not significantlyexceed its average. This offers an idea that the current crisis and preceding fall of stock

markets was a further continuation of stock market fall in 2000, which followed after the boom of stock prices in 90s.


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Conclusion

The research of a P/E ratio in a role of an indicator of the future stock markets falls does notresult in clear conclusion. Analysis rather confirms that price earnings short-term deviationsfrom its average might sign a correction that will push the value of P/E back to its average (asillustrated by sudden stock market fall in 1987).

In horizon 1 to 3 years, the deviations of P/E above its average were historically found prior to the stock market falls, evidenced by stock market falls in 1973 and 2000. Contrary, thiscannot be applicable for stock market fall in 2007, which seems to be rather continuation of the stock market fall in 2000, which followed after the stock market rally of 90s.

In time horizon of 5 years, the observations did not confirm P/E as an indicator that wouldallow indicating future falls of stock markets.


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References

BASU, S.: Investment Performance of Common Stocks in Relation to Their Price-Earnings Ratios: A Test of The Efficient Market Hypothesis , The Journal of Finance, 32, 3, June 1977

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