DOES HIGH PRICE EARNINGS RATIO PREDICT FUTURE FALLS OF STOCK PRICE?

MARIN VOREK

University of Economics in Prague Faculty of finance and accounting 31 August 2009

Abstract This paper examines the strategy of value investing and its further possibilities for prediction of stock performance, especially in connection with falls in stock prices. The methodology used is based on the implications of the theory of financial markets and the methodology of fundamental analysis. The value investments analysis prepare estimates of a common stocks intrinsic value by multiplying the respective multiplier (e.g. P/E, P/S, P/CF, P/BV) times the respective actual quantity of stocks earnings, sales, cash flow, book value, etc. Price to earnings ratio is one of the most used and frequently discussed. The price earnings ratio and its dynamics are determined by current stock price and by earnings per share. Having tested historic yields of stocks in relation with their level of price earnings ratio, the analysts have discovered that there is a negative correlation between the stocks yield and its level of price earnings ratio. Consequently, the above outcome has been further developed into a strategy called the strategy of low price to earnings ratio. This strategy was subject to the further research of which results have doubted the efficient market theory. The research discovered that the investments into stocks with low price to earnings ratio achieved higher than average returns. Based on the above mentioned methodology and the outcomes of empirical studies, this paper focuses on the other side of that relation, whether the high price to earning ratio predicts the future falls in stock prices and whether the price to earnings ratio could act as an indicator of the coming bear market. Key words: price to earings ratio, P/E, low P/E, high P/E, stocks performance, value investing

Preface Hopefully, global economy is through or at least close to the end of, recession, which was triggered by U.S. sub-prime mortgage sector in 2007. It seems that almost every world economies were affected by this recession. The university researchers and market analysts search for its causes. Some of them say that the primary causes have arisen from the cheap money policy supported by low interest rates; the other seek it in risk evaluation of derivatives and securitization of assets. The buyers of such derivatives are not able to estimate the corresponding risk level. Nevertheless, recessions are unfavorable part of economy as it develops in cycles. Despite the fact that recessions are being sensed negatively, their presence lead the particular market subjects to more efficient behavior, which contributes to better efficiency of the whole system. This cannot stop scientists who still try to explain how to predict the crisis periods and to find indicators that might predict the crises.

Introduction Financial crises result in destructive impacts on respective economies (recessions) and deep downfalls of financial markets. Therefore, several authors aim to address the questions regarding factors that cause the crises, ways how to solve them or how to precede them. Researchers concentrate effort to create a conventional model that would propose an explanation and could simulate an economic environment prior to and during the crisis. However, there is yet no general theory that would be able to answer all the questions. Therefore, none of proposed approaches has been accepted yet. This unfavorable outcome may have its roots in very broad foundation, where particular crises may arise from. These considerations end up in other questions whether the crises may even be predicted and whether there are exact indicators/parameters that may detect the thread of these unfavorable market conditions. The financial markets usually anticipate recessions, and thus the first negatively affected. However, some of the financial market turmoils are being triggered without any rational causes and are being driven just by herd behavior of market players. The bearish markets could be characterized with a loss of confidence in market valuation of securities. Hence, all subjects focus on closing of their risk positions and minimal losses which triggers the sale wave resulting in deep fall of security prices. Subsequently, volatility of security prices raises as a result of unsteady foundation in security valuation models. The market researchers and analysts seem to be able forecast the key economic drivers by application of some growth rate during the time of economic growth. However, none of them has ever projected coming declines in advance. This paper points to the well known investment strategies based on value investing theory and its multiples; and searches for its potential reverse application in indicating the financial markets fall in advance.

Theoretical Foundation Value investing is an investment theory that derives from the ideas of Ben Graham and David Dodd formed in their text Security Analysis (1934). The main idea involves buying securities whose shares appear underpriced by some of its fundaments1. Such securities might be traded at discounts of book value, sales or earnings multiples. The essence of value investing is buying stocks at less than their intrinsic value, where intrinsic value is the discounted value of all future distributions. This approach has evolved significantly since 1970s. The most successful Grahams student is Warrant Buffet, who runs Berkshire Hathaway. One of the investments strategies is derived from undervalued basic fundaments which are expected to determine the stock price. This is typical for stocks traded with discount and at low multiples of sales (Price to Sales), book value (Price to Book Value), earnings (Price Earnings) and cash flow (Price Cash Flow). From long term prospective, the investment strategies based on the investments into stocks with low multiples result in comparably higher annual return. Success of these strategies is illustrated on picture below.
Picture 1 Annual return of the strategies based on the multiples

Source: www.dreman.com

Graham, Benjamin (1934). Security Analysis New York: McGraw Hill Book Co., 4

Data showed on picture 2 demonstrate the recent development of P/BV, P/E and P/S multiples of indices S&P 500 and PX (index of Prague Stock Exchange) during the current crisis (March 2005 to March 2009). The pictures prove that the multiples are not stable and might indicate economic environment.
Picture 2 Development of trading multiples of S&P 500 index and PX index (March 2005 March 2009)

Source: Bloomberg

There was a decline in trading multiples of S&P 500 and PX prior to the current crisis. The multiples of S&P 500 peaked in summer 2007, when stocks were traded at 3 times multiple of book value, which means that investors valued the company 3 times higher than its accounting value of the equity. Price earnings and sales multiples amounted to 17, 1.6 respectively. Then, in September the trading multiple fell down to 1.8 for book value multiple, 12 for price earnings ratio and 0.6 for sales multiple. The multiples of Czech stock market index PX has developed very similarly to S&P 500. However, the volatility of index PX has been higher and the index peaked earlier at the beginning of 2007. Picture 2 might also illustrate the fact that investors were willing to invest at higher trading multiple in the period prior to crisis. While during the crisis the trading multiples bottomed down.

Further in the theory section, the text is focused on one particular measure which is based on ratio of stock price (P) and earnings per share (EPS or E). Price to earnings is an indicator which indicates current mood of investors how much they are willing to pay per unit of company earnings. The stock price and the earnings per share determine the value of the ratio. P/E increases when investors are willing to pay more per unit of earnings while the earnings remain stable. P/E also grows when both the stock price and the earnings per share increase, however, the increase of stock price must be sharper than the increase in the earnings per share. Another scenario of increasing P/E take place, when stock price remain stable despite there is a decrease in the earnings per share. The price earnings ratio does not change when there is a balance between the growth of the stock price and the earnings per share. On contrary, P/E declines when the willingness of investors to pay price per unit falls as well as when the price paid per stock by investors increases in slower pace than the earnings per share, etc.
Exhibit 1 Analysis of movements of price earnings ratio

Price earnings

Price

Earnings per share

Action Price earnings ratio increases due to higher price, while earnings (EPS) remain stable. Investors pay higher price per unit of company earnings. Stock price grows in higher pace than company earnings. Subsequently, this leads to higher P/E. Investors react on growth of company earnings. Investors may have high expectations of future growth or overvalued the current growth of company earnings. Despite a decrease in company earnings the stock price remains stable. Investors do not react on the decrease of company earnings. Stock price decreases in slower pace than company earnings. Investors have not reflected full impact of company earnings decrease into stock price. Stock price increases despite the decrease of company earnings. Investors do not reflect decrease of company earnings in stock price.

This very brief attempt points to the fact that the P/E growth might symbolize misbalance between the growth of stock price and growth of company earnings, which might be caused by different expectations of company future. Furthermore, the main specifics of the ratio are derived from profit models and are based on the following equation: P=E/k+R where P stands for stock price, E earnings per share, k discount rate and R is net present value of future growth opportunities2. Based on the preceding formula, P/E ratio might be reformulated as: P/E = 1 / k + R / E. This equation determines further the key drivers of the P/E ratio. On one hand, P/E is positively driven by the future growth opportunities, as already suspected, and negatively by demanded rate of return in denominator set as discount rate.3 Thus, one can expect that the companies with high growth opportunities such as IT/IS stocks in 1990s would have high P/E ratios while the P/E of companies with limited growth opportunities such as railroad companies, food chains, airlines, etc. would be dramatically lower4. The low level of P/E might be also explained as a so called effect of neglected companies or effect of small companies. The size of the business is too small, that the analysts do not pay enough attention to analyze it or analyzing it would not be efficient. In many cases, the small companies do not dispose information that would allow reasonable analysis. Nevertheless, this should not be valid for market indices.
2 3

Ross, Westerfield, Jaffe: Corporate Finance, page 121 Muslek, P.: Financial markets and investment banking, page 264 4 This might also explain so called burst of technological stocks in 2001.

The second parameter that influences P/E is the discount factor that is related to current interest rate. Hence, it is the current interest rate and its fluctuation which might contribute to volatility of P/E. Due to simplicity of P/E ratio, authors, researchers and investment public form various types of it. Differences amongst them arise from time coincidence between the earnings per share and current price, resp. substituted by intrinsic value of the stock. Other approach that differentiates this ratio and is derived from intrinsic value calculation uses different earnings. These might be either current earnings or expected earnings. The expected might be calculated from a formula that is based on the last published earnings and one from the following: earnings growth rate, management expectations or estimates of analysts. The following constructions of P/E are well known: The most simple and also most exploited is current price earnings ratio. This approach forms a ratio of current stock price and last posted earnings per share. This P/E works as a benchmark for other constructions of P/E. Thus, it is a basic measure for P/E based on intrinsic value and statistical methods derived from regression analysis. Due to its simplicity, the outcomes of this calculation are presented in stock recommendations, stock analysis, stock lists, etc. Normal P/E5 is based on Gordon dividend model transformed into profit model6. One of the underlying assumptions says that a part of company profit (earnings) is retained (b) and a part is paid out as a dividend (p). The (b) + (p) must equal to 1. IV0 = D1 / (k-g) IV0 = E1 * p / (k-g) P0 / E1 = p / (k-g)7 Where IV0 intrinsic stock value k demanded rate of return
5 6

Cipra Tom, Mathematics of securities, page 118 Dividend discount model with constant growth 7 Vesel Jitka, Securities analysis, part II, page 188 - 198

E1 expect earnings in time period t+1 D1 dividend in time period t+1 g dividend growth rate p dividend pay-out ratio V0 = (P/E)N * E1 Where (P/E)N equals to P0 / E1.

And dividend D1 is defined in time period t+1 as: D1 = p * E1 Further transformation of the formula leads to the determinants of current P/E. These are earnings growth rate, demanded rate of return, and dividend pay-out ratio. The impact of the first two was described in the above text. The impact of dividend pay-out ratio depends on a relation between ROE and demanded rate of return. Should ROE exceed demanded rate of return, then increase of dividend pay-out growth leads to lower P/E. Contrary, should ROE be lower than demanded rate of return, then an increase of dividend pay-out ratio results in higher P/E. Other type of P/E ratio is Sharps P/E, which arises from expected earnings instead of current earnings. IV0 / E0 = p* (1+g) / (k-g) Where IV0 stock intrinsic value E0 current earnings k demanded rate of return g earnings growth rate p dividend pay-out ratio In case that earnings growth rate does not equal to zero, the Normal P/E and Sharps P/E8 differ just by a variance caused by the earnings growth.
8

http://www.stanford.edu/~wfsharpe/

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The difference between Sharps and current P/E serves as an indicator, whether current stock price is undervalued or overvalued compared to its intrinsic value represented by Sharps P/E. The higher Sharps P/E indicates that the stock price is undervalued and contrary. Historic P/E is different approach calculated as an average of historic P/Es. Assumed is, that P/E moves in a range around its long-term average. A difference between the current P/E and the historic average symbolizes whether current stock price is priced correctly. Other construction of P/E is represented by regression P/E, which is calculated on the basis of regression formula that simulates changes of P/E based on its parameters. The parameters are derived from historic values of P/E and its key drivers. Once the formula is filed out with input data, it results in regression P/E.

P/E = + *g + *p + *, Where , , , regression coefficients, g... earnings growth rate, p... dividend pay-out ratio, ... risk rate. Also regression P/E might be exploited for an analysis whether the current stock price is undervalued or overvalued. The last approach is known as P/E of comparable companies. This formulation of P/E compares the current P/E of one particular company with other peer companies of comparable parameters and similar business conditions. The practical investment strategies are based on the picking of stocks with low P/E or finding the intrinsic value of the company and comparing that with the current parameters. These strategies are being connected with so called low P/E effect or low P/E anomaly. The historic verification of the low P/E strategy has confirmed existence of low P/E anomaly which assures higher than average returns9.
9

S. Basu: The Investment Performance of Common Stock in Relation to their Price-Earnings: A Test of the

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Dreman verified the low P/E strategy on a sample of historic data consisting of 1,250 stocks in the period between 1968 and 1977. Outcomes of his study are summarized in a table below.
Exhibit 2 Annualized returns of portfolios (Dreman study)

Portfolio 1. Highest P/E 2. 3. 4. 5. 6. 7. 8. 9. 10. Lowest P/E

3M -2.64% 0.92% 0.51% 3.06% 2.19% 4.84% 7.90% 8.83% 11.85% 14.00%

6M -1.06% 1.62% 0.62% 3.42% 4.46% 5.33% 6.07% 8.24% 8.40% 11.68%

12M -1.13% 0.56% 1.63% 3.31% 2.93% 6.70% 6.85% 8.56% 6.08% 10.26%

36M -1.43% -0.28% 0.85% 4.87% 5.02% 4.82% 5.89% 7.78% 7.73% 10.89%

108M 0.33% 1.27% 3.30% 5.36% 3.72% 4.52% 6.08% 6.35% 6.40% 7.89%

Source: G. Smith: Investments, Scott and Foresman Company, 1990, p. 370

Steven Bleiberg verification research based on the data between 1938 and 1989 has resulted in similar outcomes, which are summarized in table below.
Exhibit 3 Annualized returns (%) in Bleiberg study

Fifth by P/E level 1. 2. 3. 4. 5. Total

% of observations 40 13 15 11 21 100

6M 1.55% 1.99% -1.32% -2.06% 6.59% 1.54%

12M 2.73% 4.87% -2.15% -0.41% 12.37% 3.98%

24M 0.41% 7.52% 5.35% 3.08% 20.95% 7.01%

Source: S. Lofthouse: Equity Investment Management, 1994, page 249

The confirmation of the existence of low P/E anomaly in stock markets denies the effective capital market theory as described by E. Fama in 197010.

Efficient Market hypothesis, Journal of Finance no. 32, 1977, D. A. Goodman, J. W. Peavy: Industry Relative Price-Earnings Ratios as Indicators of Investment Returns, Financial Analysts Journal no. 39, 1983 D. Dreman: The New Contrarian Investment Strategy, New York, Random House, 1982 S. Bleiberg: How little we know about P/Es, but also perhaps more than we think, Journal of Portfolio Management no. 15, summer 1989, page 26 31 10 E. Fama: Efficient Capital Markets: A Review of Theory and Empirical Work, Journal of Finance, 25, p. 383417, 1970

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Empirical Observations Based on the empirical data, the price earnings ratio might have been used for a construction of successful investment strategies. Could be this approach reverted and could it also work as an indicator for predicting of future stock market lows? Could high levels of P/E ratio predict future falls of stock markets? The chart below shows the development of S&P 500 index and its P/E between 1964 and 2009. In this period, there were four significant downturns of financial markets. The first is related to oil shocks in early 70s; the second happened in 1987, when the stock markets suddenly dropped; and next two falls were seen in 2001 and 2007 which were connected to a burst of dotcom bubble and to the U.S. subprime mortgage crisis, respectively.
Exhibit 4 Development of S&P500 index and its price earnings between 1964 and 2009
1800 1600 1400 1200 1000 800 600 400 200 0 29.1.1954 29.1.1957 29.1.1960 29.1.1963 29.1.1966 29.1.1969 29.1.1972 29.1.1975 29.1.1978 29.1.1981 29.1.1984 29.1.1987 29.1.1990 29.1.1993 29.1.1996 29.1.1999 29.1.2002 29.1.2005 29.1.2008 5.00 10.00 20.00

S&P 500 P/E AVG P/E

30.00

25.00

15.00

Source: Bloomberg

The exhibit also illustrates that the P/E is very volatile indicator that historically fluctuated around its long term average. In different periods, the level of P/E differed and experienced both the sharp growths and sudden declines. Especially in the crisis periods, the P/E dropped

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to its long-term lows, as the uncertainty of market valuations froze the investors appetite. The same happened with other EV11 multiples such as book value, cash flow or sales. Back to the original question, whether the price earning ratio might foresee the future stock market falls. To analyze the observations, the regression and correlation analysis has been used. The histograms were constructed for indices S&P500 and PX12. The charts describe the dependency of annualized return of index S&P500 (in the chart showed on the x axis) on the level of P/E in investment horizon of one year. The regression line has slightly negative slope which confirms the assumption that the future returns are negatively correlated with the price earnings ratio. Nevertheless, the R square parameter results at 0.039, which means that only 3.9% of price movements could be interpreted by the P/E. The next picture simulates the case in higher investment horizon of 5 years. The slope of regression line is negative again. The regression coefficient R square amounts to 0.318. Thus, 31.8% of price movements could be interpreted by changes in P/E. The longer investment period brings more significant results in terms of R square. Another difference between observations with 1 year and five years horizon arises from P/E values exceeding 30. In the longer investment horizon period, each observation point with P/E higher than 30 results in negative annual return. This might implicate that investments in this period (P/E exceeds 30) are not profitable in the long-term horizon. The similar exercise has been performed with index PX and is illustrated in exhibit 6. However, the data for the Czech environment are limited to an interval between 2001 and 2008 only. Contrary to assumptions, this example ends in positive slope of regression line. Regression coefficient R square amounts to 0.052. The same simulation with five years investment horizon ends up with the negative slope of regression line and R square rises to 0.0896. This might be caused by the very short period of the research which covers exactly one cycle of bull and bear markets. Nevertheless, the data of this short period confirms assumption that high level of P/E might cause a fall of stock prices in the near future. Thus, P/E might act as a warning indicator.

11 12

EV = Enterprise Value PX = index of Prague Stock Exchange

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Exhibit 5 Annualized return of S&P 500 with investment horizon 1year and 5 years respectively (1967 2008)
30%
60.00% Annualized Return (Investment Horizon 1Y)

25% Anualized Return Investment Horizon 5Y 20% 15% 10% 5% 0% 5.00 -5% -10% 15.00 25.00 35.00

30.00%

0.00% 5.00 10.00 15.00 20.00 25.00 30.00 35.00 -30.00%

-60.00% P/E

-15% P/E

Regression formula R square Standard deviation No. of observations

y = 0.174 0.006 * P/E 0.039 0.164 10,380

Regression formula R square Standard deviation No. of observations

y = 0.139 0.004 * P/E 0.318 0.070 9,398

Source: own calculations, Bloomberg Exhibit 6 Annualized return of PX with investment horizon 1year and 5 years respectively (1967 2008)

40% 35%
100%

30%

Annualized Return Investment Horizon 5Y

80% 60%

25% 20% 15% 10% 5% 0%

Annualized Return Investment Horizon 1Y

40% 20% 0% 5 -20% -40% -60% -80% 10 15 20 25 30 35 40 45

-5% -10%

15

25

35

P/E

P/E

Regression formula R square Standard deviation No. of observations

y = -0.014 0.011 * P/E Regression formula 0.052 R square 0.290 Standard deviation 1,831 No. of observations

y = 0.531 0.018 * P/E 0.895 0.034 826

Source: own calculations, Bloomberg

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The following charts highlight the relation between future annual return of S&P 500 index and its P/E in periods prior the respective crisis and in periods during these crises.
Exhibit 7 Annualized return of S&P500 with investment horizon 5 years respectively (1967 2008) 1972
1.00% 0.00% 10.00 -1.00% -2.00% -3.00% -4.00% -5.00% -6.00% P/E

1973-1974
14.00% 12.00% 10.00%
15.00 20.00 25.00 30.00

Annualized Return Investment Horizon 1Y

8.00% 6.00% 4.00% 2.00% 0.00% -2.00%5.00 -4.00% -6.00% -8.00% P/E 10.00 15.00 20.00 25.00

1986-1987
Anualizovan v nos indexu S&P500 v horizontu 5 let 12.00%

1987-1989

Anualizovan v nos indexu S&P500 v horizontu 5 let

10.00% 8.00% 6.00% 4.00% 2.00% 0.00% 5.00

14% 12% 10% 8% 6% 4% 2% 0% 5.00

10.00

15.00 P/E

20.00

25.00

10.00

15.00

20.00

25.00

P/E

1999-2000
0% 5.00 10.00 15.00 20.00 25.00 30.00 35.00 -1% -2% -3% -4% -5% -6% P/E

2000-2002
15.00% 10.00% 5.00% 0.00% 5.00 -5.00% -10.00% P/E

10.00

15.00

20.00

25.00

30.00

35.00

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The take-aways from the exhibit are not unique for each crisis. In period prior to oil shock crisis in 1972, the level of P/E amounted to approx. 20. During the crisis the P/E level fell down to 7 8. In the example of 1987 stock price fall, P/E rose sharply from 12 to 22 in preceding year. The sudden fall of stock prices returned the P/E back to 10. In the 90s, the stock prices boomed. Analysts interpreted the stock price boom with new information technologies. Even in short time prior the burst of that bubble, analysts commented on this matter and argued with new IC/IT technology that justifies the high level of P/E. P/E reached its maximum of 30. The bubble burst in 2001 and the P/E ratio fell to 15.
Exhibit 8 Development of price earnings ratio during the selected crisis Oils shocks 1987

Dotcom bubble

U.S. subprime mortgage

Source: Own calculations, Bloomberg

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The level of P/E ratio in period preceding the current crisis amounted to 17, which was comparably less than the level in 2001. The subsequent stock market turmoil, which anticipated the world recession, pushed it down to 11. The historic values of P/E and its development in decades between 1954 and 2009 are shown in exhibit 8. Before stock market fall in 1987 and before the burst of dotcom bubble in 20000, the level of P/E exceeded significantly its long term average. Especially during 90s, price earnings ratio jumped beyond 30. However, subsequent downturn backed the multiple to the level of long term average around 16. Similar observations are shown in exhibit 9, which illustrates development of P/E arithmetic mean of S&P500 in particular year. The chart is constructed for a 5 years prior and 5 years after the year of the stock market fall. This might disclose whether, price earnings ratio might be used as an indicator for prediction of future stock market falls.
Exhibit 9 Annual return of S&P500 and its average price earnings ratio 1968 1978
P/E 1954 - 2009 P/E 1968 - 1978 P/E 17.58 16.84 16.46 14.01 14.89 18.64 18.96 16.28 10.23 10.00 12.34 9.93 8.82

30.0% 20.0% 10.0% 0.0% -10.0% -20.0% -30.0% 1968 8.1% -11.4% 1969 -0.9% 1970 1971 1972 12.0% 16.1%

28.4% 18.2% 2.4% 1978

-18.1% 1973

-29.8% 1974 1975 1976

-11.1% 1977

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1982 - 1992
P/E 1954 - 2009 P/E 1982 - 1992 P/E 30.0% 20.0% 10.0% 0.0% -10.0% -20.0% -30.0% 1982 1983 1984 1985 1986 14.6% 19.2% 8.01 12.51 16.46 14.90 11.02 11.30 27.8% 15.5% 8.5% 2.0% 0.3% 1987 1988 1989 -8.2% 1990 1991 27.8% 4.4% 15.89 19.27 14.10 13.30 28.4% 15.17 18.53

1992

1995 - 2005
P/E 1954 - 2009 P/E 1995 - 2005 P/E 16.58 34.2% 19.3% 19.20 16.46 21.87

22.33

25.30

28.88

27.26

22.96

22.27

19.16

18.92

17.46

40.0% 30.0% 20.0% 10.0% 0.0% -10.0% -20.0% -30.0% -40.0%

31.7%

26.1%

19.6% -9.3% -10.5% 2001 -23.8% 2002

22.3% 9.3% 3.8% 2005

1995

1996

1997

1998

1999

2000

2003

2004

2002 2009
P/E 1954 - 2009 P/E 2002 - 2009 P/E 22.27 19.16 16.46 17.87

18.92

17.46

16.57

16.75

15.63

11.39

40.0% 30.0% 20.0% 10.0% 0.0% -10.0% -20.0% -30.0% -40.0% -23.8% 2002 2003 2004 2005 2006 2007 22.3% 9.3% 11.8% 3.8% 3.7% -37.6% 2008 -11.2% 2009 2010 2011 2012

Source: Own calculations, Bloomberg

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Stock market fall in 1973 was not preceded by price earnings ratio higher than 30. However, P/E exceeded its average in each of those 5 years prior to 1973. Price earnings ratio after the crisis decreased by half compared to its level before the stock market turmoil. Interpretation of the stock market decline from 1987 might be different. It seems like it was just one-off correction that resulted in decline of P/E which has been above average only during the year 1987. Nevertheless, the S&P500 ended with positive annual return in that year. At the beginning of 80s, P/E level was relatively low. Subsequently, the values of price earnings ratio grew from 8 to 18. Burst of the so called dotcom bubble in 2000 was in line with assumed scenario. Since 1995 on, the P/E ratio grew from 16 to more than 28. After the burst in 2000, the P/E returned to its long term average. Compared to 70s, the decrease was rather gradual. The last picture of exhibit 9 shows the current economic crisis development in terms of P/E development and stock prices behavior. The intensity of the fall of price earnings ratio is fully comparable with 70s. Contrary to 70s, the level of price earnings ratio did not significantly exceed its average. This offers an idea that the current crisis and preceding fall of stock markets was a further continuation of stock market fall in 2000, which followed after the boom of stock prices in 90s.

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Conclusion The research of a P/E ratio in a role of an indicator of the future stock markets falls does not result in clear conclusion. Analysis rather confirms that price earnings short-term deviations from its average might sign a correction that will push the value of P/E back to its average (as illustrated by sudden stock market fall in 1987). In horizon 1 to 3 years, the deviations of P/E above its average were historically found prior to the stock market falls, evidenced by stock market falls in 1973 and 2000. Contrary, this cannot be applicable for stock market fall in 2007, which seems to be rather continuation of the stock market fall in 2000, which followed after the stock market rally of 90s. In time horizon of 5 years, the observations did not confirm P/E as an indicator that would allow indicating future falls of stock markets.

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References BASU, S.: Investment Performance of Common Stocks in Relation to Their Price-Earnings Ratios: A Test of The Efficient Market Hypothesis, The Journal of Finance, 32, 3, June 1977 BREALEY, R. A., MYERS, S. C., Principles of Corporate Finance, The McGraw-Hill, 2003 DREMAN, D. BERRY, M.: Overreaction, Under reaction and the Low-P/E Effect, Financial Analysts Journal, July/August, 1995 FRANCIS, J.C. Investments Analysis and Management. 5thEdition, The McGraw-Hill,1991 HAUGEN R. The Incredible January Effect MAYO, H.B. Investments, An Introduction. The Dryden Press, 1998 MUSLEK, P. Security Markets. Praha, Ekopress, 2002 PLUMMER, T. Prediction of Financial Markets. Computer Press, 2008 ROSS, S. A.- WESTERFIELD, R. W. Jaffe, J.: Corporate finance, McGraw Hill, 2002 SHARPE, W.F., ALEXANDER, G.J. Investments. Praha, Victoria Publishing, 1994 TREVINO, R., ROBERTSON, F. Journal of Financial Planning: P/E Ratios and Stock Market Returns. February 2002 VESEL, J. Analysis of Security Markets, I. and II. part. VE, 1999

Bloomberg Thomson Investment Banker www.pse.cz www.akcie.cz

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