Predictive Power of PE ratio and Stock Returns.
Price Earnings (NYSE:PE) ratio is widely used by investors in considering whether stocks are cheap or expensive. Investors generally have a point estimate as to what the stock may perform over future period like 6 months, 1 year and so on. In my earlier blog I had mentioned what information is implied in the PE ratio. In the recent research from Joseph Diaz of Vanguard they have shown PE ratio have a very poor predictive ability in the short run of 1 year. It has predictive capability of only 40% over a long period of 10 years on inflation adjusted returns. The research covers period from 1926 onwards and various predictive powers of various factors. Investors should be aware of the inherent limitations of predictive powers of various factors.
Here is the link to the article.