JUNE 1977 INVESTMENT PERFORMANCE OF COMMON STOCKS IN RELATION TO THEIR PRICE-EARNINGS RATIOS: A TEST OF THE EFFICIENT MARKET HYPOTHESIS S. BASU* I. INTRODUCTION IN AN EFFICIENT CAPITAL MARKET, security prices fully reflect available information in a rapid and unbiased fashion and thus provide unbiased estimates of the underlying values. While there is substantial empirical evidence supporting the efficient market hypothesis,' many still question its validity. One such group believes that price-earnings (P/E) ratios are indicators of the future investment performance of a security. Proponents of this price-ratio hypothesis claim that low P/E securities will tend to outperform high P/E stocks? In short, prices of securities are biased, and the P/E ratio is an indicator of this bias.3 A finding that returns on stocks with low P/E ratios tends to be larger than warranted by the underlying risks, even after adjusting for any additional search and transactions costs, and differential taxes, would be inconsistent with the efficient market hypothesis? The purpose of this paper is to determine empirically whether the investment performance of common stocks is related to their P/E ratios. In Section I1 data, sample, and estimation procedures are outlined. Empirical results are discussed in Section 111,
The Journal of Finance – Wiley
Published: Jun 1, 1977
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