Empirical Testing On P/E Phenomenon Of China Stock Markets

PE is the cost that the investors pay for the per profit of the listing company, equaling to the years needed to withdraw the initial investment. But the precondition is that the company maintains the level of profits as well as 100% payoff. The supporters of this idea believe the stock with lower PE ratios has high valuation. However, PE Ratio is also the growth potential of the company. Therefore high PE means high estimation the investors hold for the stock. Such companies will have high growth in the following year. Investors will benefit from analyzing PE Ratio, for it is helpful for judging the risks and value of the stock. The goal of this text is to test whether P/E Ratio has significant effects on future stock returns, and how.There are sufficient studies of the P/E phenomenon in the foreign literatures. The scholars have found that lower P/E portfolio has higher returns than higher P/E portfolio by testing the returns of the two different portfolios. This article adopts the general regression model, introduces different variables including P/E Ratio, Market Value, Growth of Earnings, and Cumulative Market Return to test the existence of PE phenomenon in China's Shanghai and Shenzhen stock markets during 2001-2007. The results of the general regression model show the significant effect of P/E Ratios on Cumulative Returns, which means the higher P/E Ratios is, the lower CR is. The investors will get the higher CR by holding the stocks with lower P/E Ratio. The article goes further to test the significant of P/E effect in different industries. Picking the industries with high, median and low average P/E Ratio, with the regression analysis, the article finds that P/E has no significant effect on CR in these industries, but the average P/E Ratio of the industry does. Meanwhile, because of the fact that P/E is inverse ratio to the size of the company, divide the stocks into four groups by the size of the company. It produces evidence with the cross-sectional regression that P/E phenomenon appears under the constraint of the size, as the P/E is negatively to the subsequent equity performance. At last, collecting the data during 1998-2006, the article generates the relationship between P/E Ratio and Earnings Growth of next year. The methodology is also based on regression analysis. The resulting evidence documents that higher P/E -higher Earning growth is justified. But, all in all, it's not enough to make investment decision based on the level of P/E alone, other factors are equally important such as CMR.