FE rapport,
University of Gothenburg, Department of Business Administration

Abstract: For stock analysis, the P/e ratio has always played a prominent part. Is it, then, a good method for finding “incorrectly” evaluated stocks? Earlier research mainly based on the situation in North America has given some support that this would be the case. Recently, however, K L Fisher has maintained that this would be misleading. The aim of this study is to investigate if there is a connection between the P/e ratio and future return on the Swedish market. The study was carried out on the Swedish market, i.e. index, as a whole and using data from 1979. The theoretically correct way to assess companies is to discount the expected cash flows. The connection of the P/e ratio to this method is only valid in the specific case when the dividends on the own capital equals or is close to the stock market’s demands for dividends for the object in question. Even if the theoretical basis for the utility of the P/e ratio is weak, it can be shown that empirically on the Swedish market, there has been a significant connection, with a time lag of one to two years between P/e ratio and future dividends. The ratio is of little importance for the total dividends and, inflation deducted, the P/e ratio, at the most, explains a mere 19 % of the total variations in the dividends.

Keywords: Price earnings ratio; stock analysis; stock evaluation; return prediction

18 pages, April 28, 2008

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