Anomaly Between Securities Having Low and High Price-Earnings (p/e) Ratios

Just over fifty years ago, Nicholson (1960) found an anomaly between securities having low and high price-earnings (P/E) ratios; his studies found that securities with a low ratio deemed value stocks earned significantly higher returns than their high-ratio counterparts deemed growth stocks. At first glance, the PE ratio is an awkward number. The numerator is a market based trading price which is long term and forward looking in nature while the denominator is often a historical accounting number collected for one financial year. It seems reasonable to expect this combination to be rather meaningless. Yet, the ratio remains one of the most popular techniques for valuation, and investors keep relying on this seemingly futile measure. While the low P/E effect has been extensively studied in international markets, there is a notable absence of UK market-based P/E studies. This finding directly contradicts the EMH, which states that all available information is incorporated in security prices. This phenomenon was investigated by many empirical studies mainly in the US but there have many other studies across world markets who found similar results, starting with Basu (1977), and many more which is discussed in the literature review. However when one researches through all the previous studies, the value effect seems persistent in all major stock markets around the world. This paper analyses the P/E effect on financial companies listed on the LSE for the period of 2006-2010.The primary question asked in this dissertation is:

Is there a connection between the P/E ratio and subsequent stock returns and thus be able to generate a trading strategy that yields excess returns?

The paper analyses this question by using different regression models, where the explanatory variable is the P/E ratio (earnings yield respectively) and the dependent variable is represented by the subsequent stock return.

Implications for the study for the academic community

* Test the applicable characteristic of theories from advanced countries, proof for the efficient market hypothesis.

* Proof of the EMH

For investment Community

* Meaningful information for investment strategy

* Anchor to develop style investment strategies.

Many investors try to identify securities that are undervalued, and are expected to increase in value in the future, and particularly those that will increase more than others.