Return Predictability using Price-to-Earnings Ratio

Abstract

In this paper, I revisit the predictive ability of the price to earnings (PE) ratio for future returns. I provide a model of expected returns by decomposing stock price into earnings and PE ratio. While the PE ratio is modeled as a mean-reverting AR(1) process, earnings follow a linear trend. Expected model returns are strongly correlated with future returns. An increase of 1% in expected returns is associated with 0.5% higher future returns. To this end, I propose an investment strategy that chooses between equity or debt investment based on predicted expected stock returns and risk-free bond returns. My strategy avoids short-selling and outperforms a buy-and-hold portfolio of stocks.