Researchers double the power of the price-earnings ratio – University of Reading
04 April 2006
New research by Keith Anderson in the ICMA Centre at the University of Reading and Chris Brooks (Cass Business School)* has made it possible to almost double the power of the price-earnings ratio (P/E) to predict returns, by taking multiple years of past earnings into account in the P/E calculation. The findings show that the power of the price-earnings ratio (P/E) has until now been seriously underestimated due to taking too short-term a view of earnings. Fund managers could gain a significant competitive advantage by changing the way they calculate the P/E. That low P/E shares tend to outperform high P/E shares (the 'price-earnings effect') has been known for decades, but whether multiple years of earnings are more useful than earnings from the most recent year in predicting returns has not been investigated until now. Looking at all UK companies since 1975 and using the traditional P/E ratio, Anderson and Brooks found the difference in average annual returns between the value and glamour deciles (the 'value premium') to be 6% - similar to other authors' findings. But they were able to almost double the value premium by calculating P/E ratios using earnings averaged over the last eight years. Averaging, however, implies equal weights for each past year. The premium can be enhanced further by optimising the weights of the past years of earnings when constructing the P/E ratio. They examined several plausible weighting rules for the past years of earnings. Earnings from two or three years ago have a particularly poor predictive ability, whereas the individual earnings figures from five, six, seven or eight years ago, divided by the current share price, are better predictors of returns than the traditional P/E. This is testament to the limitations of the usual P/E ratio for predicting returns. Keith Anderson said, 'Our results are clear: multiple years of earnings are a better predictor of returns that the traditional one-year P/E. An eight-year average is twice as effective, generating arbitrage strategy returns of almost 12% per year. We can further improve our results by optimising the weights, because the value premium does not increase in a straight line as more past years are added into the calculation.' * Anderson, K. & Brooks, C. 2006. The Long-Term Price-Earnings Ratio. Journal of Business Finance and Accounting (forthcoming) Ends For media enquiries please contact: Keith Anderson, ICMA Centre, University of Reading T: 0118 378 8239 E: keithanderson@icmacentre.rdg.ac.uk Eleanor Holmes, Press Officer at the University of Reading T: 0118 378 6166 E: e.m.holmes@rdg.ac.uk