INTRODUCTION

In recent years investments in equities have increased manifold. This is evident

from the fact that a large number of scrips have been listed in the stock exchanges in the last few
years as well as from the significant increase that has taken place in the daily turnover of the
market of the market. With the entry of the market. With the entry of foreign institutional
investors (FIIS) in the Indian bourses, coupled with stronger activity of domestic financial
institutions and arrival of private mutual funds; the erstwhile rule of stock picking has matured
from speculation to research based investment. There is an increased awareness about the need
for investment analysis and many financial analysts are looking at various parameters in
assessing the performance of corporate in the stock market.

It is generally found to be convenient to identity a single indicator which can be used to reflect
the changes in the underlying fundamentals pertaining to a scrip. Equity researchers are however
divided in their opinion regarding the single parameter which represents the fundamentals of a
scrip and hence EPS, RONW, P/BV or P/E ratio etc. are used for this purpose.

Objective of the study

We attempt in this paper to examine whether the price to earnings ratio (P/E) is a good criterion
on which to base investment decisions. In other words we want to test P/E stocks. That is,
whether low P/E ratio signifies that the market has undervalued the form and to that extent
whether it would be able to provide better returns compared to high P/E scripts.

LITERTURE SURVEY:
The price to earnings ratio is the single most popular tool for equity valuation. The inherent
simplicity in understanding its significance has made it particularly popular among ordinary
investors.The investments analysts also give P/E ratio its due importance before making
investment decisions and for timing the entry into or exit from a stock.

Basu (1977) showed how the price earning ratio that is computed from reported accounting
earnings can be used to select stocks that have good price appreciation potential. His analysis
showed that stocks with low P/E ratios earned risk-adjusted rate of return that beat the returns
earned by a native buy and hold strategy.

The price/earning ratios of Japanese firms are known to be higher than those of other countries.
Bierman(1991) points out that P/Es of Japanese firms are considerably overstated because of
widespread reciprocal ownership in Japan. In his opinion, when large amounts of common stocks
are held by coporations, and when dividend payouts are low,asis common in Japan, P/E can be
substantially inflated. Another study by Lkeda M.(1992), however claims that such upward bias

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of P/E ratios is not necessarily due to crossholdings alone.Instead the P/E adjustments process
should take into account different levels of scales,earning and payouts ratio that are
interconnected by different degrees of reciprocal ownership.

Some researcher have shown that P/E ratio is a combination of present and future growth
rate.Leibowitz and Kogleman (1992) establish that the price/earning ratio of a firm with no
franchise value gives the base P/E which is simply the reciprocal of the market capitalization
rate.By contrast,the P/E of a firm with substantial franchise is fully consumed. Firm
earnings,dividends and price will grow at a single (generally lower) rate,determined by the
market rate and the firm’s retention policy.The authors later(1994) have shown that the current
growth rate of a firm which although greater than market average, yet not in excess to its
expected franchise opportunities.On the other hand,high earnings derived from franchise
opportunities are already reflected in the firm’s P/E multiple and hence draw down the franchise
opportunities which in turn pulls down the P/E value.Hence,firms which constantly extend their
firm’s valuation will be able to maintain higher P/E ratio.

Evans (1993) finds that the usual stock market rule of 20 – which says the P/E ratio plus
the inflation rate should equal 20- no longer holds true. He suggests that the rule might have lost
its validity and many are trading at much higher P/E ratios, but there still exist some fundamental
relationship between the yield on stocks and bonds.

Another valuation indicator for analysis is the ratio of market value to book value since
under theoretically ideal conditions the market value of a firm should reflect its book value. The
ratio is important if it is believed that the company’s book value per share has some relationship
to the stock’s economic worth. For example, if the company is liquidated and its assets sold for
their book value, the book value per share will provide the floor on the stock’s price. But this is
not so in reality because liquidation value of assets are generally much lower than their book
values. The higher a company’s price to book ratio, the more likely it is overvalued, whereas,
lower the ratio the chances are that it is undervalued. Companies with a market to book ratio less
than one, are serious candidates for undervaluation and represent good possible buys.

Some have suggested that stocks with low P/E ratio should outperform high P/B stocks
just as stocks with low P/E ratios outperform stocks with high P/E ratios.

Wilcox (1984) showed that the P/B- ROE model appears to be a better valuation model
than the P/E model. A study by Rosenberg at al (1985) examined this aspect and found that
stocks with low P/B ratios experienced significantly higher risk adjusted returns than average
stocks.

Fairfield (1994) establishes that the price/earnings ratio is a function of expected changes
in future profitability. Together the ratios reveal information about expected future profitability
relative to current profitability. The evidence indicates that different P/E and P/B combinations
are associated with distinct patterns of future profitability.

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 Several attempts have also been made to find the effect of firm size and earnings/price
ratio in relation to equity return. Basu (1977) claims that earnigs/price rario subsumes the size in
sample specific cases. Another study by Reinganum (1981) found that size subsumes the
earnings/price ratio due to fotuitous choice of methods. Cook and Rozeff (1984) later examined
the joint effect of size and earnings/price ratio and their findings suggest that both effects are at
work, i.e. one is not subsumed by another as claimed by previous works.

A more recent study by Fama & French (1992) provided ever greater support for this
ratio as a measure of relative value. The purpose of the study was to examine alternative
variables that would explain the cross-section of the rates of return on common stocks. One of
the explanatory variables was the well known beta coefficient. Their results did not provide
much support for beta as an explanatory variable but the results did reveal that both the size of
the firms and the ratio of book value to market value of equity were significant explanatory
variables. They also contended that the book value to market value ratio was the single most
important variable.

Penman (1996) in his study explains that the P/E ratio indicates the future growth in
earnings which is positively correlated to expected future return on equity and negatively related
to current return on equity. Empirical evidence indicates differential P/B ratios but not P/E ratios
except in the extremes. Current return on equity is not a good indicator of P/E since a given level
of P/E can be associate with alternatives combinations of current and future return on equity.

Cole et al (1996) examine the predictive power of traditional market indicators like
dividend yield and market to book ratio and claim that these are no longer valid indicators. They
find that share repurchase activity has not been especially high trough most of the 1990s and that
after adjusting for buybacks the dividends yield remains low. Likewise the market to book ratio
remains at a record high once charges for retiree liabilities have been taken into account.

These studies were conducted for European,US and Japanese markets.A recent study by
Agrawal et al (1996) carried out on Singapore market data,investigated the usefulness of the P/E
ratio as a valuation model. They conclude that the identified fundamental variables which are
supposed to determine the value of the firm also explain a significant portion of the price to book
value ratio.Therefore the latter can be used as a proxy for the formea.

A study on the Indian stock market by R.Vaidyanathan and Chava(1997) examined the
hypothesis that the investment in low P/E stocks on an average will give higher returns than
high P/B stocks.The study used 70 active scrips over a period of six years and found that the
returns are not significantly different P/B stocks.

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Methodology
Sample selection

The sample selected consists of the scripts belonging to the sensex as these scripts are generally
liquid. They also exhibit relatively large market capitalization and large floating stock. This
selection of sensex scripts is to eliminate issues pertaining to lack of trading, illiquidity etc. Only
the scripts which have been traded through out the period 2005-2006 to 2008-2009 have been
considered. Bajaj auto and maruti udyog are not considered as it was not traded through this
period. Reliance communication and reliance energy are also not considered as they come in
sensex group later on.

The final sample consists of 24 scripts which all are actively traded from the period of 2004-05
to 2008-09. The data pertaining to scripts in the sample were taken from www.bseplus.in site.

Portfolio construction
At the beginning of each year the price to EPS ratio of the scripts is calculated and the scripts are
sorted out in the descending order of the P/E ratio.

Portfolio return
The return are calculated for each of the scripts from the beginning of April to the beginning of
the next year (i.e. annual return)

For example: - for the year 2004 -05 the returns for scripts is

(p06april-p05april)/p05april.

Hypothesis
We wish to test the proposition that in low P/E stocks on an average will give higher
returns than investment in higher P/E stocks.

The null hypothesis can be stated in the form of

H0: ui=uj for each pair of portfolios i and j at the 95%confidence level.

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Limitations
We were not able to consider 4 scripts in to portfolio construction as we have taken
equally weighted portfolios.

We have considered returns without adjusted with risk

Transaction cost is ignored.

Analysis is limited up to sensex scripts.

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Analysis:-

portfolio Mean t-value s.e. 2tail-sign

(1,2) 26.23 1.75 15.21 .119
(1,3) -5.73 -1.54 3.72 .158
(1,4) 24.27 1.59 15.22 .145
(1,5) -20.84 -1.76 11.85 .113
(1,6) 20.9 1.37 15.30 .205
(1,7) -16.47 -4.35 3.78 .002
(1,8) 21.81 1.46 14.96 .179
portfolio Mean t-value s.e. 2tail –sign
(2,3) -31.96 -1.692 18.88 .125
(2,4) -1.97 -4.88 .4035 .001
(2,5) -46.10 -1.72 26.88 .121
(2,6) -3.06 -5.77 .529 .000
(2,7) -5.02 -10.7 .471 .000
(2,8) 4.42 9.43 .46 .000
portfolio Mean t-value s.e. 2tail-sign
(3,4) 29.99 1.59 18.90 .147
(3,5) 15.11 1.84 8.19 .058
(3,6) 27.93 1.48 18.86 .173
(3,7) 10.74 2.65 4.05 .026
(3,8) 21.81 1.46 14.96 .173
portfolio Mean t-value s.e. 2tail-sign
(4,5) -45.10 -1.67 26.87 .128
(4,6) 43.05 1.61 26.82 .143
(4,7) 4.37 .421 10.38 .684
(4,8) -42.65 -1.60 26.61 .143
portfolio Mean t-value s.e. 2tail-sign
(5,6) 43.05 1.61 26.82 .143
(5,7) 4.37 .421 10.38 .684
(5,8) 42.65 1.60 26.61 .143
portfolio Mean t-value s.e. 2tail-sign
(6,7) -38.67 -2.31 16.71 .046
(6,8) -0.397 -1.23 .32 .248
portfolio Mean t-value s.e. 2tail-sign
(7,8) 38.28 2.32 16.51 .046
Note: - the results for the portfolios with the lowest P/E ratio were not found to be
significantly different from those of the portfolios with high P/E ratios at 95% confidence
level. (See above table)

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Conclusion:

The test reveals that the annul average returns of the portfolios formed on the basis
of the P/E ratios are not found significantly different from each other. This hold
true for 17combinations. Hence the null hypothesis is not rejected in 17
combinations. Hence it seems that P/E ratio may not be the appropriate measure in
our context to conclude regarding stock return.

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Bibliography
1. WWW.bseplus.in

2. www.indiainfoline.com

3. www.religareonline.com

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