Price-earnings ratios and stock returns: Evidence from selected indices
This report examines whether price-to-earnings ratio (P/E) and dividend yield influence future price for a select few value-weighted, equity capital market indices, over the period July 1995 through June 2013. The relationships are modelled for the S&P 500, FTSE 100 and FTSE/JSE All Share series indices, using vector autoregression (VAR). Impulse response analysis is then conducted and the forecast error variance is decomposed into its constituent parts. Finally, Granger causality tests are run. The VAR estimates suggest that an increase in P/E leads to an expected increase in price, in two months’ time, but only for the S&P 500 and FTSE 100 indices. From the parameter estimates, it is expected that an increase in dividend yield does not significantly impact price except for the FTSE 100 and FTSE/JSE All Share where it has a negative relation. Price is found to be mean-reverting, with shocks to price dying out within three to four months. In general, virtually none of the variance in price can be directly attributed to the valuation ratios. For most of the indices, there is very little evidence of Granger causality, in either direction, between price and P/E and between price and dividend yield. There appears to be Granger causality in both directions between price and P/E in relation to the FTSE100.