TITLE

What Determines Earnings-Price Ratios: Revisited

AUTHOR(S)
Zarowin, Paul
PUB. DATE
June 1990
SOURCE
Journal of Accounting, Auditing & Finance;Summer90, Vol. 5 Issue 3, p439
SOURCE TYPE
Academic Journal
DOC. TYPE
Article
ABSTRACT
This article analyzes what determines earnings-price ratios. The earnings-price ratio is believed to capture the market's assessment of the equity' s risk and earnings growth prospects. Prior research, however, has found that neither risk nor growth can explain persisting cross-sectional differences in earnings-price ratios. This paper shows that persisting cross-sectional differences in forecasted long-term earnings growth are the dominant source of variation in earnings-price ratios, and that the conclusions of prior research were due to the use of realized growth as a proxy for forecasted growth, since the two measures are not highly correlated. Other factors, such as risk (beta), forecasted short-term growth, and accounting method seem to be relatively less important in determining earnings-price ratios. Using an expectational database not available to previous researchers, the research conducted here shows that the dominant determinant of the cross-sectional variation and time-series persistence of earnings/price ratios is forecasted long-term growth in earnings per share. Additional factors such as accounting method choice, forecasted short-term growth, and risk (beta), appear to be relatively unimportant in determining E/P ratios. While the significance of the forecasted growth factor reconfirms the central role of expectations in the pricing of shares, the lack of significance of beta is another piece of evidence casting doubt on its importance. This statistical result may be due to errors in variables biases, but the portfolio construction method is designed to minimize that problem. Determining which specific risk factor(s) is (are) used by the market to set share prices is, of course, an important avenue of future research.
ACCESSION #
7299808

 

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