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Does investor sentiment affect price-earnings ratios?

Does investor sentiment affect price-earnings ratios? PurposeA large number of empirical studies investigate the determinants of price-earnings (P/E) ratio by focusing on fundamental factors. However, there has been an increasing concern that stock valuation is also driven by investor sentiment. This paper aims to extend the existing literature by exploring whether investor sentiment impacts the P/E ratio.Design/methodology/approachThe paper examines the determinants of P/E ratio by applying latent variable models with investor sentiment as a latent variable and several fundamental factors as control variables. Investor sentiment is proxied by trading volume, advance-decline ratio and price volatility.FindingsUsing annual data of the US industries over the period of 1998-2014, the current paper produces new empirical evidence that investor sentiment significantly affects the P/E ratio. This result is robust to the inclusion of several control variables that have been documented to explain the P/E ratio.Practical implicationsThe findings have important implications for investors, as downplaying sentiment can lead to significant errors in making equity investment choices based on the P/E ratio.Originality/valueThe analytical framework of the current paper is differentiated from the conventional analysis in which the P/E ratio is regressed against control variables and proxies for sentiment, thus falling into the trap of implicitly presupposing that proxies are perfect measures of investor sentiment. As all proxies may have measurement errors to the true but unobservable investor sentiment, the current paper uses latent variable models to shed new light on the influence of investor sentiment on the P/E ratio. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Studies in Economics and Finance Emerald Publishing

Does investor sentiment affect price-earnings ratios?

Jitmaneeroj, Boonlert
Studies in Economics and Finance , Volume 34 (2): 11 – Jun 5, 2017
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Publisher
Emerald Publishing
Copyright
Copyright © Emerald Group Publishing Limited
ISSN
1086-7376
DOI
10.1108/SEF-09-2015-0229
Publisher site
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Abstract

PurposeA large number of empirical studies investigate the determinants of price-earnings (P/E) ratio by focusing on fundamental factors. However, there has been an increasing concern that stock valuation is also driven by investor sentiment. This paper aims to extend the existing literature by exploring whether investor sentiment impacts the P/E ratio.Design/methodology/approachThe paper examines the determinants of P/E ratio by applying latent variable models with investor sentiment as a latent variable and several fundamental factors as control variables. Investor sentiment is proxied by trading volume, advance-decline ratio and price volatility.FindingsUsing annual data of the US industries over the period of 1998-2014, the current paper produces new empirical evidence that investor sentiment significantly affects the P/E ratio. This result is robust to the inclusion of several control variables that have been documented to explain the P/E ratio.Practical implicationsThe findings have important implications for investors, as downplaying sentiment can lead to significant errors in making equity investment choices based on the P/E ratio.Originality/valueThe analytical framework of the current paper is differentiated from the conventional analysis in which the P/E ratio is regressed against control variables and proxies for sentiment, thus falling into the trap of implicitly presupposing that proxies are perfect measures of investor sentiment. As all proxies may have measurement errors to the true but unobservable investor sentiment, the current paper uses latent variable models to shed new light on the influence of investor sentiment on the P/E ratio.

Journal

Studies in Economics and Finance – Emerald Publishing

Published: Jun 5, 2017

References

  • Decomposing the price-earnings ratio
  • Panel data models with interactive fixed effects
  • Investor sentiment in the stock market
  • A model of investor sentiment