CFA Institute

What Determines Price-Earnings Ratios?

Author(s): William Beaver and Dale Morse
Source: Financial Analysts Journal, Vol. 34, No. 4 (Jul. - Aug., 1978), pp. 65-76
Published by: CFA Institute
Stable URL: http://www.jstor.org/stable/4478160
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by WilliamBeaverand Dale Morse

What Determines
Price -EarningsRatios?
> Recent studies on the behavior of earnings
growth over time raise doubt about the ability of past
growth to explain differences in price-earnings
ratios. Eitherfuture growth is difficultto predict, or
investors are basing their predictions on information
other than past growth.
Grouping common stocks into portfolios on the
basis of price-earnings ratios, the authors find that
the initial P/E differences among the portfolios
persist up to 14 years. Growthappears to explain
little of the persisting P/E differences, however.
Price-earnings ratios correlate negatively with
earnings growth in the year of the portfolio's
formation, but positively with earnings growth in the
subsequent year, suggesting that investors are
forecasting only short-lived earnings distortions.
Nor does risk supply the explanation for these
differences. Although price-earnings ratios can vary
either positively or negatively with market risk,
depending on the market conditions in a given year,
market risk is of little assistance in explaining the
observed persistence in price-earnings ratios over
periods longer than two or three years.
The authors conclude that the most likely
explanation of the evident persistence in price-
earnings ratios is not growth or risk, but differences
in accounting method. >
proach,we examinethe behaviorof P/E ratiosand
explore the ability of earningsgrowth (hereafter
growth)and risk to explain P/E ratio differences
acrossstocks.We find that,althoughdifferencesin
P/E ratiospersistfor up to 14 years,growthandrisk
appearto explainlittleof this persistency.In partic-
ular, growth appearsto have virtuallyno effect
beyondtwo years.>
Valuation Theory
Underperfectmarketsand certainty,the priceof a
securityis equal to the presentvalue of the future
cash flows. Over an infinite horizon, the current
pricewill reflectthe streamof dividends.Underthe
furtherassumptionsof (1) a constantdividendpay-
out ratio (K), (2) constantgrowthin earningsper
share(g) and (3) a constantrisklessrate(r), P/E is
givenby the Gordon-Shapiro valuationequation:
P/E=rKg ( (1 )
In a certaintyworld,earningspershare(E) can be
defined as that constantcash flow whose present
value is equivalentto the presentvalueof the cash
flows generatedfrom current equity investment.
Where the investmentinvolves assets with finite
lives, this definitionimplicitlyreflectsthe fact that
the value of the assets will depreciateover their
lives.3We adopt this definition,which is often re-
ferredto as permanentearnings.Absentfurtherin-
vestment,or if the earningsrateon futureinvestment

T HE PRICE-EARNINGS ratio(hereafterP/E 1. Footnotes appear at end of article.

ratio)is of considerableinterest,yet little is
known about how it behavesover time or William Beaver is Thomas D. Dee, ll Professor of Ac-
School of Business, Stanford
aboutthe relativeimportanceof the factorsbelieved counting at the Graduate
University. Dale Morse is a Ph.D. candidate at the
to influenceits behavior.Differencesin expected Graduate School of Business, Stanford. Financial sup-
growtharecommonlyofferedas a majorexplanation port for their research was provided by the Stanford
for differencesin P/E ratios. Yet recent research Program in Professional Accounting, the major spon -
raisesdoubt about this interpretation; past growth sors of which are Arthur Andersen & Co., Arthur
andanalysts'forecastsappearto havelittleabilityto Young & Co., Coopers & Lybrand, Ernst & Ernst,
explain subsequentgrowth.'Using a portfolioap- Peat, Marwick, Mitchell & Co. and Price Waterhouse.

1978 O
ANALYSTSJOURNAL/ JULY-AUGUST
FINANCIAL 65
is r, the P/Eratiois simplythe reciprocalof the risk-
less rate (I/r). The P/E ratio will reflecta growth
"premium"(or discount) only when the rate of
returnon futureinvestmentexceeds(or falls below)
the risklessrate,r.4
When the world is no longer certain, it is no
longerclearwhatthe "earningsterm"in Equation1
is intendedto represent.The earningsconceptun-
derlyingmarketprices is future-oriented,hence is
definedin termsof the expectationsof marketpar-
ticipants.As such, it is not directlyobservable,but
presumablyrepresentssome formof expected per-
manentearningspershareattributable to the current
equityinvestment.
A second consequenceof uncertaintyis that,
alongwith E, the actualvaluesof the variablesr, g
andK arealsounknown.Eachsymbolin Equation1
is ofteninterpretedas the expectedvalueof the cor-
respondingvariable.When Equation 1 is used to
analyzethe behaviorof currentprices,these vari-
ablesarecommonlyinterpreted as a "consensus" ex-
pectationacross investors.5While there are prob-
lemsin usingEquationI in this manner,it maystill
be a reasonableapproximationof a morecomplex
valuationprocess.
A thirdconsequenceof uncertaintyis thatthe ex-
pectedreturnis no longerthe risklessrate,butrather
a riskyrate.Since stockswill differwith respectto
risk, the expected risky rate for stock i will be
denoted ri. In the one-periodcapital asset pricing
model (CAPM), differencesin the expectedrisky
rateof returnaredue solelyto differencesin beta-
the sensitivityof the stock to returnon the general
marketrm.In particular:
ri - rf + bi(rni- rf), (2)
whereriis theexpectedrateof returnon securityi, rf
the risklessrate,rmthe expected rateof returnon
the marketportfolioand bi securityi's sensitivityto
marketrisk,or beta.
Moreover,actual earningsper share (EPS) will
vary from year to year becauseof transitory(i.e.,
temporary)factors peculiar to a particularyear.
Therefore,actualearningsmay differfromthe ex-
pectedearningsuponwhichmarketpricesarebased.
This leadsto the distinctionbetweenthe transitory
versusthe permanentcomponentof EPS.This dis-
tinctionwill becomecrucialin interpretingour re-
sults.6
Research Design
A portfolio approach potentially diversifiesout
some of the "noise"at the individualstock level.
We selectedstocksthat satisfiedthe followingcri-
teria:(1) five consecutiveyearsof dataon the Com-
pustatandCRSPtapes(the latterimpliesNewYork
Stock Exchangemembership)and (2) a fiscal year
endingon December31.
For each yearfrom 1956 through1974 we com-
putedthe P/E for each stock withdataavailablein

TABLE 1: Median Values of Variables

Median
Percentage
No. of Median Growth Median
Year Stocks P/E in EPS Beta*
1956 270 11.55 0.981
1957 279 10.08 -3.63 0.952
1958 284 17.61 -8.94 0.959
1959 295 15.75 20.73 0.954
1960 354 15.29 -4.83 0.964
1961 373 19.68 1.56 0.959
1962 398 14.98 8.39 1.007
1963 409 15.46 9.00 0.981
1964 435 14.45 19.42 0.960
1965 464 15.18 18.19 0.952
1966 493 11.60 13.01 0.975
1967 514 16.91 -0.69 0.967
1968 548 19.43 7.52 0.991
1969 581 14.04 5.31 0.998
1970 600 15.58 -10.16 0.939
1971 600 17.06 9.92
1972 600 14.07 20.46
1973 600 7.45 23.10
1974 600 5.01 12.37
1975 600 8.04 -1.21
*A stock's beta for 1956 is computed over the 60-month period following December
1956 (January 1957 through December 1961), according to the method described in
Footnote 8.

66 O FINANCIAL
ANALYSTSJOURNAL/ JULY-AUGUST
1978
 thatyear.We definedP/E as pricepershareon De- medianannualgrowthratesreportedin Table 1 and
cember31 dividedby earningspershareforthe year, the growthin aggregateEPS for S&P Industrials
computedon a pre-extraordinary item basis.Using yieldeda positivecorrelationof 0.89.12
datafromthe Compustattape, we definedearnings
growthas the percentagechangein the year'searn- How Do P/E Ratios Behave OverTime?
ings per share relativeto the previousyear and Table 2 reportsthe rankcorrelationbetweenP/E
measuredrisk as the stock'sbeta, computedfrom ratiosin the yearof formationandP/E ratiosin sub-
monthlystock price returndata availableon the sequentyears.'3The firstrowof Table2 displaysthe
CRSPtape.8 correlationsbetween the P/E ratios of portfolios
We then rankedeach year'sstocks accordingto formedin 1956 andthe P/E ratiosof the sameport-
P/E and formed25 portfolios,with PortfolioOne folios in subsequentyears.The secondrowdisplays
comprisingthosefourpercentwiththe highestP/E's resultsfor portfoliosformedin 1957 and the final
and Portfolio 25 comprisingthe stocks with the row the correlationbetweenthe P/E ratiosof the
lowestP/E's.We thencomparedthe medianP/E for portfoliosformedin 1974andthe P/Eratiosof those
each portfolioin its base year (year of formation) sameportfoliosin 1975. For example,for the port-
with the medianP/E, medianrealizedgrowthand folios formedat the end of 1956,the correlationbe-
medianrisk for the portfolioin subsequentyears.9 tweenportfolioP/E ratiosin 1956 (the yearof for-
Note that, in all cases, once formedthe portfolio's mation)and 1957 (one yearlater)is 0.96. The rank
compositionwasfixed(i.e., a buy and hold strategy correlationbetweenthe P/E ratiosin 1956 and 1966
was used).'0 (10 yearslater)is 0.74.
Table 1 reportssomesummarystatistics."Oncea The mediancorrelationof each column is re-
stockappearson the tapein a givenyear,its dataare portedat the bottomof the table.The mediancorre-
availablefrom that year onward.The similarityof lationsare not strictlycomparablefor severalrea-
stocks appearinglater relativeto those appearing sons. First,the groupof calendaryearsover which
earlieris supportedby the medianbeta,whichshows the medianis computedgraduallychangesas one
no trendovertimeandis closeto one. Whenwe cor- movesacrossthe columns:Oneyearafterformation
relatedthe medianP/E for eachyearwiththe aggre- includescalendaryears 1957 through1975, while
gate P/E ratio for Standard& Poor's Composite 14 years after formationincludes only calendar
stocksfor the years1956 through1975,we obtained years1970through1975.Then,too, the medianP/E
a positiverankcorrelationof 0.85, whichis reason- ratiovariesconsiderablyby calendaryears,as Table
able, given the differencesin the stocks and the 1 indicates,droppingsharplyin 1973, 1974 and
methodsusedto computethe averageP/Efora given 1975.Table 1 alsoshowsthatthe averagenumberof
year.Furthermore, the rankcorrelationbetweenthe stocksper portfoliodiffers;in 1956 the numberof

TABLE 2: Rank Correlations of Portfolios Formed By P/E Ratios With P/E Ratios in Subsequent Years
Base Years Following Base Year
Year 1 2 3 4 5 6 7 8 9 10 11 12 13 14
1956 0.96 0.87 0.88 0.65 0.78 0.70 0.82 0.85 0.69 0.74 0.62 0.36 0.41 0.59
1957 0.85 0.91 0.83 0.84 0.89 0.89 0.90 0.81 0.86 0.72 0.51 0.67 0.78 0.44
1958 0.95 0.73 0.64 0.52 0.43 0.55 0.49 0.30 0.60 0.22 0.24 0.49 0.41 0.18
1959 0.96 0.91 0.91 0.73 0.57 0.88 0.74 0.69 0.33 0.46 0.69 0.56 0.40 0.56
1960 0.94 0.94 0.93 0.89 0.88 0.79 0.70 0.63 0.80 0.73 0.61 0.61 0.50 0.24
1961 0.98 0.96 0.86 0.89 0.85 0.76 0.74 0.87 0.83 0.87 0.76 0.72 0.55 0.64
1962 0.92 0.89 0.93 0.94 0.87 0.69 0.86 0.73 0.78 0.76 0.87 0.78 0.77
1963 0.99 0.98 0.95 0.89 0.71 0.77 0.75 0.61 0.79 0.93 0.77 0.76
1964 0.95 0.96 0.94 0.72 0.88 0.89 0.72 0.88 0.90 0.81 0.82
1965 0.99 0.93 0.83 0.83 0.77 0.86 0.93 0.91 0.80 0.71
1966 0.96 0.89 0.95 0.96 0.84 0.95 0.89 0.80 0.79
1967 0.98 0.98 0.94 0.89 0.85 0.58 0.57 0.69
1968 0.98 0.95 0.88 0.84 0.63 0.53 0.35
1969 0.89 0.92 0.95 0.74 0.80 0.82
1970 0.95 0.79 0.63 0.72 0.73
1971 0.96 0.80 0.70 0.67
1972 0.96 0.96 0.96
1973 0.99 0.97
1974 0.97
Median
Correlation 0.96 0.92 0.91 0.83 0.80 0.78 0.74 0.76 0.79 0.73 0.69 0.64 0.50 0.44

1978 L 67
ANALYSTSJOURNAL/ JULY-AUGUST
FINANCIAL
 stocksis 10, whilethe baseyears1970through1974 enth year afterformation.Afterthe eleventhyear,
average 24 per portfolio. On purely statistical furtherconvergenceoccurs until, in the fourteenth
grounds,the correlationcoefficientshould rise as year,Portfolio25 hasa P/Egreaterthanthatof Port-
the numberof stocksper portfolioincreases.How- folio One's.
ever,Table2 does not displayanyobvioustendency We takethis to meanthatthe effectof the factors
for the correlationsto increasesystematically in the determiningP/E ratiosin the yearof formationdis-
laterbase years.'4 sipatesdramaticallyby the third year afterforma-
With these caveats in mind, we interpretthe tion. On the other hand, the fact that the conver-
correlationsin Table 2 as supportinga long-term genceof P/E ratiosis by no meanscompleteimplies
persistencyin the portfolios'P/E ratios.With only that certainfactorsare still causingdifferencesin
two minordisruptions,the mediancorrelationde- P/E ratios throughat least the eleventhyear after
clines steadilywiththe numberof yearssince port- formation.
folio formation.Five yearsafterformationthe me- The patternof reversiontowarda centralvalueis
dian correlationis 0.80, while 10 yearsafterforma- a commonphenomenonamongeconomicvariables.
tion the mediancorrelationis 0.73. Fourteenyears Researchon the behaviorof betaindicatesa similar
afterformation,the medianis 0.44. We tentatively pattern.Two factorsexplainsuchbehavior:(1) The
concludethat,althoughmuchof the effectof thefac- variablebeingrankednormallycontainsa transitory
torsthatdetermineP/E ratiosdissipatesoverthe 14 component;in our context,this meansthatearnings
years,a portionstill clearlyremainsafterfive, 10 or in a givenyearresultin partfromfactorspeculiarto
perhapseven 14 years. thatyearwhoseeffectswill eithernot persistbeyond
This conclusionis supportedby Table 3, which that year or will dissipatein subsequentyears.(2)
displaysa compositepictureof six of the 25 port- The underlying,permanentvalueis revertingtoward
folios.'5We averagedthe P/E ratiosacrossthe base the average.Sucha reversionin the ratioof priceto
years,weightingeachyearby the numberof stocksin expectedearningsper sharecould be causedby a
that year.'6The strikingfeatureof Table 3 is the changein expectedearningsgrowthor by a change
shrinkageovertimein the P/Edifferencesamongthe in risk.
portfolios.Not surprisingly,this tendencyis most Examiningthe time series behaviorof the P/E
evidentin the extremeportfolios(i.e., PortfoliosOne ratioprovidessomeinsightintothe natureof the fac-
and25). The P/Eof PortfolioOneis lessthanhalfits torsthatinfluenceit. Apparently,someof thesefac-
value one year afterformation,and less than one- torsdissipatesubstantially
withinthe firstthreeyears
thirdits valuetwoyearsafterformation.Portfolio25 afterformation.On the otherhand,some continue
showsa similarreversiontowarda centralvalue,as effectivethroughat leastthe eleventhyearafterfor-
do other portfolios,for which the patternis, how- mation.We will considerthree potentialfactors-
ever, less pronounced. growth,risk and accountingmethod.
As a convenientsummary,Table 3 reportsthe
ratioof the P/E valuesfor PortfolioOne relativeto Does Growth Explain Differences
those for Portfolio 25. In the year of formation, in P/E Ratios?
PortfolioOne'sP/E is over eighttimesthatof Port- Table 4 displayscorrelationsbetweenmedianP/E
folio 25's, while in the next year it has shrunkto ratiosin the yearof formationand medianearnings
slightlyoverthreetimesandby threeyearsafterfor- growthin the yearof and in the yearssubsequentto
mationit is less thantwicePortfolio25's P/E. Apart formation.'IColumnzero indicatesthe correlation
from this dramaticconvergenceof the P/E ratios, betweenthe P/E ratioandgrowthin the yearof for-
theirmoststrikingfeatureis the stabilityof the rela- mation.The correlationof earningsgrowthin 1957
tive differencefromthe thirdyearthroughthe elev- with the P/E ratiocomputedat the end of 1957 is
TABLE 3: Price-Earnings Ratios
Portfolio Years After Formation
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14
1 50.0 22.7 16.4 13.8 12.3 13.2 13.5 13.2 17.2 14.9 13.0 13.2 10.5 9.3 8.3
5 20.8 17.5 16.9 15.9 15.9 13.7 13.0 12.8 12.5 11.8 11.9 10.9 10.1 10.2 8.4
10 14.3 11.9 11.5 11.1 10.3 10.1 9.4 9.0 10.0 10.0 9.9 11.0 10.6 9.5 8.3
15 11.1 10.8 10.4 10.8 10.0 10.0 9.4 9.7 9.3 9.5 8.6 9.2 8.3 8.6 7.1
20 8.9 9.1 9.6 9.3 9.4 9.3 9.3 9.0 8.8 8.8 9.0 8.2 7.6 7.0 7.7
25 5.8 6.9 8.0 7.8 7.9 7.9 8.2 8.8 8.3 8.5 7.8 7.5 7.5 7.5 8.9
Port. 1
8.6 3.3 2.1 1.8 1.6 1.7 1.6 1.5 2.1 1.8 1.7 1.8 1.4 1.2 0.9
Port. 25

68 O FINANCIALANALYSTS JOURNAL / JULY-AUGUST 1978

 negative0.28. The mediancorrelationover the 19
yearsfrom 1957 through1975 is also negative0.28,
and 16 of the 19 correlationsare negative.
The negativecorrelationimpliesthat stockswith
relativelylow earningsgrowthduringthe yeartend
to have relativelyhighP/E ratios.This is consistent
with the contentionthat marketparticipantsper-
ceive that earningscontain transitorycomponents
and price stocks accordingly.'8Since we formed
portfolioson the basisof the ratioof priceto real-
ized earnings,we expectthatthe rankingwill syste-
maticallygrouptogetherstockswithtransitoryearn-
ings of the samesign. In otherwords,the portfolio
withthe highestP/E ratiowill tendto includefirms
with negativetransitorycomponents(i.e., realized
earningsbelow expectedearnings)and conversely
for the portfoliowith the lowestP/E ratio.
Table4 displaysa strongcorrelationbetweenP/E
and earningsgrowthin the yearsubsequentto port-
folio formation.The mediancorrelationfor base
years1957through1975 is 0.53, andall 19 correla-
tions are positive.Marketparticipants'perceptions
of the transitorynatureof earningswere confirmed
by actualearningsbehavior.While, in the year of
formation,currentearningswere abnormallylow
relativeto expectedpermanentearnings,in the sub-
sequentyearearningstendedto "catchup"to inves-
tors'expectationsaboutpermanentearnings.'9
In the second year after formation,the median
correlationis 0.25 and,fromthereon, growthis es-
sentiallyuncorrelatedwithP/E in the yearof forma-
tion. The rapid dissipationin subsequentgrowth
ratesis similarto the patternfor P/E ratiosobserved
in Table2. In general,the patternbehavesas if mar-
ket participants,in determiningprices,cannotfore-
cast differentialgrowthbeyondtwo years.20
One mayaskwhatthistells us aboutthe abilityof
marketparticipantsto isolate and detecttransitory
elementsin currentearningsversustheir abilityto
forecastunusualearningssituationswith respectto
additionalinvestment.Althoughthe distinctionmay
seem arbitrary,the implicationscan differsubstan-
tially.The firstprocessconcernsunusualfactorsdue
to eventsof thisyearthatwill not persist(e.g.,an ab-
normallyhigh rate of inflationor abnormallyhigh
interestrates),while the second asks questionsre-
latedto futureunusualearningsopportunities.2'
As faras we can tell, the dataprovideno basisfor
assessinghowmuchof the observedgrowthdifferen-
tial is due to each factor(althoughthe introduction
of other evidencemay permitsuch a basis).2'As a
result,we cannotprecludethe possibilitythatthe re-
sults maybe entirelydue to the detectionof transi-
torycomponentsthattakemorethanone yearto dis-
appearfromreportedearnings.It is not our inten-
tion to be undulypessimistic,but ratherto caution
againstinterpreting the figuresas solelythe resultof
marketparticipants' abilityto forecastunusualearn-
ingsopportunitieson futureinvestments.
Magnitudeof DifferentialGrowth
Table4's correlationmatrixdoes not providein-
formationon the magnitudeof differentalearnings
growth.Table 5 displaysthis informationfor the

TABLE 4: Rank Correlations of Portfolios Formed By P/E Ratios With Earnings Growth in Subsequent Years
Base Years After Formation
Year 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
1956 0.12 0.13 -0.30 0.48 0.00 -0.12 -0.62 -0.17 -0.19 -0.32 -0.08 -0.31 0.07 0.05 -0.48
1957 -0.28 0.53 -0.23 0.51 -0.07 0.02 -0.73 -0.26 0.26 -0.23 -0.01 -0.14 0.22 0.21 -0.33 -0.03
1958 -0.28 0.52 0.32 0.03 0.18 -0.15 0.19 0.29 0.11 -0.54 0.16 0.32 -0.20 -0.40 0.39 0.23
1959 -0.37 0.62 0.40 -0.12 -0.16 0.27 0.15 0.30 0.04 -0.22 0.32 0.04 -0.48 0.17 0.21 0.36
1960 -0.10 0.49 -0.15 -0.04 -0.04 0.04 -0.01 0.26 0.29 0.26 0.06 -0.13 0.09 -0.05 -0.45 0.10
1961 -0.45 0.53 0.13 0.07 -0.05 -0.03 0.27 -0.11 0.22 0.40 0.08 0.36 -0.16 -0.51 0.27
1962 -0.35 0.17 0.12 0.05 -0.26 -0.40 0.20 -0.39 0.49 -0.17 -0.19 -0.44 -0.46 0.31
1963 -0.42 0.26 0.24 0.13 0.35 0.08 0.13 0.56 -0.03 -0.27 -0.12 -0.47 0.28
1964 -0.43 0.11 -0.14 0.68 0.08 0.44 0.71 0.06 -0.21 -0.30 -0.31 0.04
1965 0.12 0.47 0.55 0.04 0.22 0.61 -0.16 -0.14 -0.15 -0.26 0.26
1966 -0.02 0.77 0.02 0.30 0.66 -0.35 -0.14 -0.38 -0.16 0.35
1967 0.18 0.74 0.41 0.12 0.05 0.39 0.01 -0.31 -0.07
1968 -0.02 0.77 0.74 0.54 0.42 -0.14 0.15 0.32
1969 0.15 0.75 0.48 0.05 -0.17 -0.42 0.58
1970 -0.19 0.90 0.58 -0.09 -0.63 0.34
1971 -0.22 0.71 0.27 -0.02 0.32
1972 -0.18 0.45 -0.09 0.39
1973 -0.31 0.52 0.51
1974 -0.66 0.89
1975 -0.66
Median
Correlation -0.28 0.53 0.25 0.05 0.06 0.02 0.14 -0.11 0.01 -0.22 0.02 -0.08 -0.18 0.07 0.24 0.10

FINANCIALANALYSTS JOURNAL / JULY-AUGUST 1978 E 69

 same six compositeportfoliosreportedin Table 3,
usingthe samecompositeprocess.The resultssup-
portthe contentionsmadeearlier.PortfolioOne(the
highestP/E portfolio)experienceda mediandrop in
earningsof 4.1 per cent, while Portfolio25 experi-
enced a medianearningsincrease of 26.4 per cent.
In simplestterms,the pricesof the stocks in Port-
folio One did not changeproportionately withtheir
earnings;as a result,theirP/E ratioswererelatively
high. Similarly,the stocks in Portfolio25 experi-
enced a pricechangethat,on average,was less than
26 percent,andtheirP/E ratioswererelativelylow.
Again, this implies a price formation process
wherebyparticipantsview changesin earningsas
containinga transitoryelement.
In Table 5, PortfolioOne showsa medianearn-
ingsgrowthof 95.3 percent in thefirstyearafterfor-
mation,whilePortfolio25 showsa dropin earnings
of 3.3 percent.This is consistentwiththe resultsre-
portedin Table4: The perceptionsof marketpartic-
ipantsregardingthe transitoryelementin earnings
wereconfirmedby subsequentearningsbehavior.
The resultsin Table5 differfromthosein Table4
in one major respect-the highest P/E portfolio
maintainsits distinctiveearningsgrowthbehavior
for sevenyearsafterformation.This is neithercon-
tradictorynor surprising.Whereascorrelationsin
Table4 reflectthe strengthof the relationshipfor all
25 portfolios,wheregrowthand P/E are essentially
unrelatedaftertwo years,the comparisondescribed
aboveinvolvesonly one of thoseportfolios.Forthat
one "extreme"portfolio we would expect non-
normalgrowthto be largerand to last longer.
The resultsin Table 5 can be deceptivein at least
two respects.First, they reflect the averageeffect
across a numberof base years and do not reveal
variationfrom one base year to another.A more
detailed examination,not reportedhere, revealed
considerablevariationacross base years. Second,
whileit is intuitivelyappealingto focussolelyon the
high P/E portfolio,it constitutesonly four per cent
of the observations.It is importantto rememberthat,
withthe remainingportfoliosincluded,thereis little
or no apparentrelationbeyondthe secondyear.
Comparingthe P/E analysis with the growth
analysis,we concludethatsomeof the initialdissipa-
tion of the P/E ratioin the firstthreeyearsafterfor-
mationcan be explainedby differentialgrowthin
earnings.Beyondthat,however,thereclearlyexistsa
P/E differentialthat cannotbe explainedby differ-
entialearningsgrowth.
Beforeleavinggrowthanalysis,we'dlike to com-
menton one aspectof the data. In contrastto P/E
ratios,which exhibit a high degreeof correlation
overtime, previousevidenceindicatesthatearnings
growthratespossessnear-zerocorrelationovertime.
To ensurethatthe samebehaviorheldforthe stocks
in our sample,we constructeda portfoliostrategy
based on earningsgrowthin the year of formation
and then observedsubsequentgrowth.Our results
confirmedpreviousfindingsof near-zerocorrelation
of earningsgrowthrates.Whilea mechanicalprocess
relyingon pastgrowthratesis largelyunsuccessfulin
predictingfuturedifferentialgrowth,the P/E ratiois
successfulbecauseprice reflectsa processwhereby
marketparticipantsrely on more informationthan
past earningsin distinguishingthe transitoryand
permanentcomponentsof earnings.
Risk Analysis
The expectedsign of the correlationbetweenP/E
andbeta maybe eitherpositiveor negative.The ar-
gumentis developedin greaterdetailin the appen-
dix, but it essentiallyproceedsas follows:Stocks'
earningsmove togetherbecause of economy-wide
factors. In years of transitorilylow earnings,the
market-wide P/Ewilltendto be high,butstockswith
high betaswill tend to have even higherP/E ratios
becausetheir earningsare most sensitiveto econ-
omy-wideevents.Conversely,in yearsof transitorily
highearnings,highbeta stockswill haveeven lower
P/E ratiosthanmost.Thereforewe expecta positive
correlationin "high"P/Eyearsanda negativecorre-
lation in "low"years.
Table6 reportsthe rankcorrelationsbetweenP/E
and beta. We comparedbeta for a givenbase year
over the 60 monthssubsequentto formation;thus
the betafor 1956 wascomputedoverthe years1957

TABLE 5: Earnings Growth

Portfolio Years After Formation
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14
1 -4.1 95.3 37.2 28.2 16.4 18.9 18.1 19.7 13.1 14.8 15.3 10.8 10.9 10.2 11.8
5 10.7 14.9 12.1 13.1 14.2 10.9 10.4 11.8 10.5 11.6 8.0 11.9 8.3 13.3 18.1
10 9.6 12.9 11.5 12.3 12.6 9.2 10.1 10.8 12.8 8.3 12.9 22.2 16.6 20.6 29.6
15 10.0 8.8 8.5 8.1 8.2 14.3 11.6 5.4 13.3 10.3 11.0 10.8 11.9 12.8 33.4
20 10.8 5.2 9.3 12.6 12.4 6.0 8.4 13.0 10.2 11.3 11.1 25.0 12.9 17.7 18.0
25 26.4 -3.3 7.5 10.8 8.3 12.9 17.1 13.6 18.0 12.8 16.7 14.2 10.9 12.4 10.1
Port. 1
-0.155 * 5.0 2.61 1.98 1.47 1.06 1.45 0.73 1.16 0.92 0.76 1.00 0.82 1.17
Port. 25
*Not meaningful because of negative growth in denominator.

70 D FINANCIAL 1978
ANALYSTSJOURNAL/ JULY-AUGUST
TABLE 6: Rank Correlations of Portfolio Median P/E andthosein whichthe correlationwasnegative.The
Ratios and Median Beta third column reportsthe beta differencesfor the
Rank of Predicted years of positive correlation.The differencesare
Rank Median Sign of small for PortfoliosFive through25, where beta
Year Correlation P/Es Correlation rangesfrom 1.09 to 0.94. The largestdifferenceoc-
1956 -0.34 14 - curs in the highestP/E portfolio,with its beta of
1957 -0.23 15 -
1.28. In the fourthcolumn,negativecorrelationis
1958 0.22 3 +
1959 0.41 5 + evident for PortfoliosFive through25, with a pro-
1960 0.50 8 + nounced aberrantbehaviorfor PortfolioOne. For
1961 0.55 1 + this set of stocks,a "U-shaped"relationshipis pres-
1962 -0.48 10 - ent. Giventhe consistentlyhighbetasof the highest
1963 -0.42 7 +b
1964 -0.63 11 -
P/Eportfolio,it is imperativethatsomeformof risk-
1965 -0.26 9 - adjustedperformancestandardbe introducedto
1966 -0.44 13 - avoidspuriouslyinferringsuperiorstock price per-
1967 0.50 4 + formance.
1968 0.53 2 + Whilebetaclearlyholdssomeexplanatorypower,
1969 0.58 12 _b
1970 0.28 6 + the crucialissueis, to whatextentdoes it explainthe
P/E ratiobehaviorreportedin Tables2 and 3? We
Median Adjusted
for Predicted 0.41
thinkit explainslittle:If betawerean importantex-
Sign planatoryvariable,then the predictedbehaviorof
a Computed fromTable 1. P/E over time would be muchdifferentfromwhat
b 1963 and 1969 are the two years incorrectly predicted. Tables2 and 3 report.Stocksin PortfolioOne dur-
ing years of high market-wideP/E would tend to
move to Portfolio25 (or its neighbors)in yearsof
through1961. lowmarket-wide P/E.Lookingacrossa rowof Table
To predictthe sign of the correlationin a given 2, we wouldexpectto see a patternof positiveand
baseyear,we rankedthe market-wide P/E ratios(as negativecorrelationssimilarto that reportedin the
reportedin Table 1) from high to low.23We hy- lastcolumnof Table6. Instead,we observea strong
pothesized that the years with the eight highest positive serial correlationthroughout.24Further-
valuesof market-wide P/E ratioswouldhavea posi- more,the relativedifferencesin betasare not of the
tive correlationbetween P/E and beta, while the same magnitudeas the relativedifferencesin P/E
yearswith the seven lowestvaluesof market-wide ratios.Beforeconsideringanothersourceof P/Edif-
P/E wouldhavea negativecorrelation.Overthe 15 ferences,however,we reportthe resultsof a regres-
base years 1956 through1970, the actualcorrela- sion analysisthat combinesboth growthand risk
tions are positive eight times and negativeseven analysis.
times.Wecorrectlypredictedthe signof the correla-
tion for 13 of the 15 years.This is impressive,given Regression Analysis
the crudenessof the test. (The test's limitationsare Table 8 displaysthe resultsof a simplelinearre-
discussedin the appendix.) gressionthat includedbeta and earningsgrowthas
Table7 reportsthe magnitudeof the betasfor the independentvariables.We usedthe EIP,ratherthan
six portfoliospresentedin Tables3 and 5. Because P/E, ratiobecausethe Litzenbergerand Rao model
the relationbetweenP/Eandbetacanbe eitherposi- posits linearityin E/P (not in P/E).25The expected
tive or negative,we averagedresultsovertwo sets of signof the E/P and beta relationshipis thusthe re-
years-those in whichthe correlationwas positive verseof that shownin the final columnof Table 6.
The actualregressioncoefficientshavethe predicted
Table 7: Relation of P/E and Beta signin 13 of the 15 years;again,1963 and 1969 are
Average Average exceptions.
Beta Beta The predictedsignsof the growthcoefficientsare
Average in Years of in Years of also negative,sincewe'reusingE/P as the dependent
Beta in Positive Negative variable.Forgrowthin the yearsubsequentto port-
Portfolio All Years Correlation Correlation
folio formation(gl), all 15 coefficientshavethe pre-
1 1.22 1.28 1.13 dictedsign.Growthtwo yearssubsequentto forma-
5 1.01 1.03 0.98
10 1.05 1.09 1.00 tion (g2)has the predictedsign in 12 years.By the
15 0.96 0.94 1.00 third year(g3),however,the signsof the coefficients
20 1.03 0.96 1.11 are evenly divided.Table 4 suggeststhere is little
25 1.04 0.95 1.14 merit to introducingadditionalgrowth variables.

FINANCIALANALYSTS JOURNAL I JULY-AUGUST 1978 O 71

 TABLE 8: E/P Regression Results
Regression Coefficients Adjusted F
(t-Statistic) R2 Statistic
Base
Year Constant Beta 91 92 93

1956 0.070 0.030 --0.046 -0.035 0.053 01523

1956 0.070 (0.71) (-1.38) (-0.73) (0.93) 0.185 2.36

1957 0.348 0.086* -0. 142' -0.066 -0.1 23' .8 .(

1957 0.348 (1.74) (-4.13) (-1.57) (-2.29) 0.581 930*

1958 0.136 0000 -0.01 9) -0.070 0.013 0.270 3.96

(0) (-2.57) (-1.69) (0.26)
1959 0.076 -0.053' -0.157* 0.098 0.086 0.505 7.13*
(-1.76) (-4.45) (1.29) (1.62)
-0.075* -0. 161'* 0.046 0.092
1960 0.155 0.502 7.06*
1960 0.155 ~~(-2.83) (-3.55) (0.71) (1.17) 0.2706

1961 0.077 -0.054* -0.063 0.064 0.023 0.289 3.44*

(-1.89) (-1.25) (0.93) (0.57)

1962 0.119 0.116* --0.055' -0.026 --0.064 0.524 7.61*

(4.68) (-2.10) (-0.50) (-1.02)

1963 0239 0.097* -0. 106* -0.089' -0.034 037452

1963 0.239 (3.10) (-1.93) (-1.84) (-0.62) 0370 4.52*

0.0076* -0.085 -0.045 -0 114'

1964
1964 0.260
0.260 0.7903
0.572 9.03*
~~(2.36) (-1.26) (-0.67) (-2.24)

1965 0.300 0.071* -0. 167* -0.091' -0-022 047644

1965 0.300 ?(2.00) (-2.54) (-1.73) (-0.32) 0.475 6.44*

1966 0.501 0.112' -0.304' -0.068 -0. 138* 0.783 22.63*

(3.53) (-7.06) (-0.96) (-1.80)

1967 0.447 -0.065* -0. 164' -0.106 --0034 05791,

1967 0.447 (_-2.15) (-2.87) (-1.67) (-0.94) 0.575 9.10'

1968 0.285 -0.031 -0.033 -0. 108; -0.060 0.738 17.91*

(-1.71) (-1.71) (-5.23) (-1.62)
-0.054 -0. 159' -0. 134' 0.030
1969 0.380 (-1.40) (0.57) 0.658 12.56*
(-4.64) (-2.09)
-0.029 -0.003 -0. 1 67* 0.089
1970 0.185 0.391 4.86*
(-0.71) (-0.28) (-2.58) (1.42)
*Significant at five per cent level (one-tailtest on regressioncoefficients).

The R2(proportionof varianceexplained)adjusted statedwhenmeasurement erroris present.(2) Better

for degreesof freedomrangesfrom 18.5 per cent to
78.3 percent,witha medianof 50.5 percent.The F-
statistic,whichteststhe nullhypothesisthatall of the
coefficientsate zero,is significantat the fivepercent
level in 13 of the 15 years."'i
Whileriskandgrowthon the averageexplainap-
proximately50 per cent of the varianceof the EIP
ratio,they obviouslyleavean equalproportionun-
explained.Thus the regressionresultspresentedin
Table 8 provideonly the crudebeginningsof an at-
temptto explaincross-sectionalP/E differences.We
suggestfurtherresearchin a numberof areas:(1)
Even if the realizedvaluesof beta and growthare
unbiasedestimatesof expectations,they may still
measurethose expectationswitherror;betterspeci-
fication could lead to higherR2, which is under-
specificationof the denominatorof the P/E ratio
might yield better results.' (3) Accountingrules
could be creatingP/E differences;our final com-
mentsare devotedto this area.
Accounting Method
The findingthat P/E ratio differencespersistwell
beyondthreeyearsafterportfolioformationsuggests
the influence of some factor other than risk or
growth.Accountingeffectsare obviouscandidates.
Accountingmethodeffectsareof twotypes- use of
differentrules(e.g.,depreciationmethods)by differ-
ent firmsfor essentiallythe sameor similarcircum-
stancesanderrorsintroducedby applyinga uniform
accountingrule (e.g., historicalcost) to differing

72 O FINANCIALANALYSTS JOURNAL / JULY-AUGUST 1978

economic circumstances(e.g., current value of (a) we have:
assets).
The P/E ratiowill be influencedby the effecton (E/Pt- E/P) = b(Mt- M) + Ut (b)
earningsof differingaccountingmethods.Assuming where E/P = expected value of E/Pt and
pricesare not dependenton the accountingmethod M = expectedvalueof Mt
used in annualreports,firmsthat use conservative
accountingmethods(e.g., accelerateddepreciation Ignoringutandtakingb equalto b, we have:
or LIFO inventoryvaluation)would tend to have - E/P) = b(Mt - M) . (c)
higherP/E ratiosthan firmsthat use less conserva- (E/Pt
tive methods,holdingconstantthe effectsof riskand Whenthe realizedMtis aboveits expectedvalue,
growth.'8For example,BeaverandDukesfoundthe stockswith higherbetaswill have higherE/P's(ex-
P/E ratiosof a portfolioof firmsusing accelerated pressed as a deviationfrom the expected value).
depreciationwere greaterthan the P/E ratiosof a However,whenthe realizedM1is belowits expected
portfolioof firmsusingstraight-linedepreciation.'9 value,stockswithhigherbetaswill havelowerE/P's
The two portfolioswere essentiallythe same with (expressedin termsof a deviationfromits mean).
respectto risk (beta) and growth.Moreover,when
the earningsof the straight-lineportfoliowerecon- Limitations of the Empirical Test
vertedaccordingto the acceleratedmethod,the P/E One obvious limitationis the failureto express
ratioswereessentiallythe samefor both portfolios. P/E (or E/P) as a deviationfromits expectedvalue,
In otherwords,the P/E differencesin the two port- as indicatedby Equation(c). This test implicitly
folios disappearedwhenearningswerecomputedon assumesthat inter-stockP/E differencesare zero.
a uniformdepreciationmethod.We suggestan ex- This is obviouslynot the case,as Tables2 and 3 in-
tensionof this type of analysisto other accounting dicate. However,we did not take this latter step
methods as an obvious candidatefor future re- sinceour concernthroughouthas beenwiththe risk
search.30U differences of a simple, P/E-oriented portfolio
strategy,not a strategythatexpressesP/E as a devia-
tion fromits expectedvalue.A secondlimitationis
the assumptionthat 15 yearstakenas a whole con-
APPENDIX tain approximately an equalnumberof realizations
If the EPSusedto computeP/E ratioscontainedno aboveandbelowthe expectedvalue,whichin turnis
transitoryelements,we wouldexpecta positiverela- assumedto be a constantover 15 years.
tion betweenE/P and beta and a negativerelation In the absenceof anyotherevidence,thisassump-
betweenP/E and beta. However,the evidencesug- tion seemsas reasonableas anyother.However,the
gests that transitoryelementsin EPS are present. assumptionof a constantexpectedvalue cannotbe
How does this affectthe analysisof risk? strictlytrue. Factorssuch as changinginterestrates
Previous empirical research indicates that a wouldleadus to expectthatmarket-wide P/E ratios
stock'sE/P ratiocan be characterizedby the follow- change over time. Third,the test ignoresthe influ-
ing (linear)process: ence of ut (the unsystematiccomponent)as ex-
pressedin Equation(b).
E/Pt=a+bMt+ut (a)
whereE/Pt = earnings-price ratiofora stockin Further Analysis of Table 7
year t, Evidencein our articlesupportsthe contention
Mt = a market-wideE/Pratioforyear t, that transitoryelementsin earningsexist.We would
expecthighP/E stocksto havegreaterearningsvari-
ut = a non-marketresidualfor a stockin abilityto the extentthattransitoryelementsaccount
year tand for P/E differences.Researchby Beaverand Mane-
gold,amongothers,confirmsthatstockswithgreater
= theinterceptandslopeof thelinear earningsvariabilityhavehigherbetas.However,the
6} relationship.
, argumentis not complete:If earningsvolatilitywere
exclusivelysystematic,we would have observedno
Moreover,this researchhas shownthat,at the port- U-shapedbehaviorin the yearswithnegativecorre-
folio level, b (the earnings-price"beta")is highly lation. If unsystematicearningsvolatility(the vari-
correlatedwith beta. anceof utfromEquation(a) ) is positivelycorrelated
In a givenyearwherethe actual,realizedearnings withbeta,and if highP/E stockshavegreaterunsys-
maydifferfromthe expectedearnings,whatrelation tematicvolatility,the resultwouldbe a consistently
can we expect betweenE/P and beta?Rearranging higher beta for the highest P/E portfolio. However, a

FINANCIALANALYSTS JOURNAL / JULY-AUGUST 1978 FO73

similarargumentcouldbe offeredforthe lowestP/E
portfolio.Yet consistentlyhigherbetasare not ob-
servedhere.We offerno explanationfor this result.
Footnotes
1. See I. Little,"HiggledyPiggledyGrowth"(Institute
of Statistics,Oxford,November1962), the seminal
work.See also R. Ball and R. Watts,"SomeTime
SeriesPropertiesof AccountingEarningsNumbers,"
Journal of Finance (June 1972), pp. 663-682; J.
CraggandB. Malkiel,"TheConsensusandAccuracy
of Some Predictionsof the Growthof Corporate
Earnings," Journal of Finance (March 1968), pp.
67-84; I. Little and Raynor, Higgledy Piggledy
GrowthAgain (Oxford:BasilBlackwell,1966);and
J. Murphy, "Relative Growth in Earnings Per
Share-Past and Future," Financial Analysts Jour-
nal (November/December 1966), pp. 73-76. Excel-
lent summariesappearin R. Brealey,An Introduc-
tion to Risk and Return from Common Stocks
(Cambridge: MITPress,1969)andin J. LorieandM.
Hamilton, The Stock Market: Theories and Evi-
dence (Homewood,Illinois:Irwin,1973).
2. Previousstudieshave attemptedto use the P/E ratio
itselfas a growthpredictor-with littlesuccess.Two
examplesare Craggand Malkiel,"Consensusand
Accuracy" and J. Murphy and H. Stevenson,
"Price/Earnings Ratiosand FutureGrowthof Earn-
ings and Dividends," Financial Analysts Journal
(November/December 1967),pp. 1 11-1 14. The port-
folio strategyadoptedin our study providesan op-
portunityto uncoverrelationsthat may have been 8. Betawasestimatedas the slopeof a linearregression
undetectedby previousresearch.
3. Let CFtequalthe cashflowgeneratedt periodsfrom
now from currentequity investment.Assumingr is
constant:
E xc
= (adjustedfor dividends)for securityi in montht and
r r 1 CFt(1 + r)-t PresentValueof Current
EquityInvestment,
E r l CFt(I + r)A-t=Permanent
t= I
, Earnings
4 It appearsto us that a basic inconsistencymayexist
whenperfectmarketsareinvokedto motivatepresent
value formulasand yet abnormalreturnsin produc-
tive opportunitiesare positedto explaingrowthpre-
miumsor discountsin P/E ratios.However,this is a
puzzlewe arenot preparedto resolve.Stocksmaystill
be priced"as if' a discountedcash flow modelwere
appliedeven in the presenceof abnormalreturnsin
the productivesector (i.e., the productand factor
markets).
5. Consensusexpectationsin generaldepend on the
wealth,riskpreferencesandbeliefsof marketpartici-
pants.("Marketparticipants"is a genericterm in-
tendedto includeindividualswhoseexpectationsdi-
rectly or indirectlyinfluence marketprices-i.e.,
analystsas well as investors.)In a one-periodsetting,
expressingpriceas a functionof expectedvaluesis an
74 O FINANCIALANALYSTS JOURNAL / JULY-AUGUST 1978
arbitrary,althoughinnoucuous,way to view valua-
tion. In a multi-period setting,however,sucha valua-
tion schemewill not necessarilyhold.
6. Previousattemptsby researchers to removetransitory
elementsfromearningsvaryfromsubjectiveadjust-
mentsof the componentsof earningsto statistical
datafittingvia Box-Jenkinstechniques.Foran exam-
ple of the latter, see P. Griffin,"TheTimeSeriesBe-
haviorof QuarterlyEarnings,"Journalof Account-
ing Research(Spring1977), 71-83.
We would like to be able to say a portfolioap-
proachwill permitus to diversifyout the transitory
earningscomponents.Clearlywe cannotmakesucha
statement.To the contrary,since the portfolioswill
be formedon the basisof the ratioof priceto real-
ized earnings,we expectthe rankingwill systemati-
callygrouptogetherstockswithtransitoryearningsof
the samesign. In otherwords,the portfoliowiththe
highestP/Eratioswilltendto includefirmswherethe
transitorycomponentis negative(i.e., realizedearn-
ingsarebelowexpectedearnings)and converselyfor
the portfoliowiththe lowestP/Eratios.Ourevidence
willsupportthesecontentions,andit is a majorpoint
to keep in mindin interpreting the results.
7. Fora moredetaileddiscussionof the effectsof aggre-
gation into portfoliossee W. Beaverand J. Mane-
gold,"TheAssociationBetweenMarket-Determined
and Accounting-Determined Risk Measures,"Jour-
nal of Financial and Quantitative Analysis (June
1975),pp. 231-284. In thiscontext,"noise"refersto
the factthatourgrowthandriskmeasuresmaydiffer
fromthe growthandriskexpectedat thetimeof port-
folio formation.
of the form:
Rit = ai + biRmt+ eit , t = 1,60
whereRitequalsmonthlypercentagechangein price
Rmtequalsmonthlypercentagechangein a market
indexof pricechanges(adjustedfor dividends)of all
NYSE firms(providedas partof CRSPtape).
9. The medianwasusedbecauseit wasa nonparametric
measurethat wouldplace less demandson the data.
Variousweightingschemes(e.g.,weightingby market
value)werealso appliedwithessentiallythe samere-
sultsas reportedhere.Since it is unclearhow to de-
fine growthoff of negativeearnings,the portfolios
were formed only over those stocks with positive
earningsin the baseyear.However,the signof earn-
ingswas unrestrictedin the yearssubsequentto for-
mation.Hence earningscould be negativein later
years.
10. The Compustattape containsthose firmsthat have
survivedmergersand bankruptcy.We wouldexpect
thatthiscould inducea potentialbias in the levelsof
the variablesto be studied. However, the study
focuseson differencesin thesevariablesacrossport-
folios of stocks.It is not obviousto whatextentsur-
vivorshipimpartsa biasfor this purpose.Thiswould
requireknowledgeof how non-survivingfirmssys-
 tematicallydifferfromsurvivingones. In any event,
because of the survivorshipcriteria,the portfolio
strategiesdescribedherecouldnot havebeenliterally
followedby an investor.
11. The numberof stocksincreasesovertimebecauseof
availabilityon the Compustattape.In virtuallyall in-
stances,the firmswithincompletehistorieson Com-
pustat existed throughoutthe 1956-75 period but
werepickedup at some laterdateby Compustat.In
otherwords,the firmsbeingaddeddo not tendto be
new firms.
12. These aggregatestatisticswereobtainedfrom S&P's
Trade and Securities Statistics, 1976.
13. It is importantto realizethata correlationmatrixlike
thatof Table2 invariablyleavesout certaininforma-
tion. For example,does a correlationcoefficientof
one meanthe P/E differencebetweenportfoliosre-
mainsapproximately the sameas it wasin the yearof
formation?Not necessarily.We can drawno infer-
enceaboutthe magnitudeof portfoliodifferences; the
rank correlation coefficient merely indicates a
similarityin the rankingsof the portfolios.A coeffi-
cient of one indicatesthat the rankingsof two port-
folios remainthe same,but it does not tell us any-
thing about the spreadbetweenthe portfolios.The
spreadbetweenthe portfoliosmay have shrunkor
grown.However,we do knowthat,evenif the spread
has changed,at leastthe relativepositionsremained
unaltered.
14. Sincethe P/E ratiosare highlycorrelated,we cannot
view elementsin one cell as unrelatedto the other
cells;the resultsin two adjacentrowsshouldbe high-
ly related.In otherwords,the resultsforthe baseyear
1957 are, not surprisingly,similarto the resultsfor
the base year 1956. Becausethe resultsare not per-
fectlycorrelated,however,someadditionalinforma-
tion is conveyedby repeatingthe portfoliostrategy
for differentbase years.
15. Table3 is subjectto the samecaveatsas Table2. For
example,the years 1971 through1975 play a rela-
tivelymoreimportantrolein the lateryearsafterfor-
mation,so the P/E ratiosexhibita downwarddrift.
The realfocal point of the table is the differencein
P/E ratiosacrossportfolios,ratherthanthe common
movementby all portfolios.Moreover,the resultsof
a moreextensiveexaminationof the data,whichheld
constantthe calendaryearcompositionof eachyear,
did not differfromthe findingsshownin Table3. We
chose Table 3's compositebecauseit was the most
comprehensive andthe simplestmethodof presenta-
tion.
16. For example,for Year0 (the yearof formation),the
averageP/E ratiofor PortfolioOnewascomputedby
takinga weightedaverageof each of the medianP/E
ratiosfor PortfolioOnefor the years1956-74 inclu-
sive. The weightsweredeterminedby the numberof
securitiesin thatportfolioin thatyear.1956,with 10
securitiesper portfolio,carrieda weightof 0.029,
while 1970-74carriedweightsof 0.070 eachwiththe
sumof the weightsoverthe 1956-74periodequalling
one.
17. Since earningscould be negativein any subsequent
year,a problemroseas to howto definegrowthwhen
the denominatoris negative.Whenearningschanged
fromnegativeto positive,the growthwasdefinedto
be greaterthanthe median(i.e., "verylarge").When
earningsremainednegativein both years,the obser-
vationwas deleted.Typically,this causeda deletion
of lessthantwo percentof the observations,withthe
exceptionof PortfolioOne, wheredeletionsranged
fromtwo to threeper cent of the observations.
18. We regardthe transitoryearningsargumentas one,
but by no meansthe only, interpretationto placeon
the results.
19. Supposeexpectedearningsper shareare $1.00. For
convenience,assumethat realizedearningsper share
were$1.00 and $0.75 in 19xl and 19x2.The actual
growthrate of 19x2 is -25 per cent, while the ex-
pectedgrowthin 19x3is 33 percent.Assumingprice
remainsessentiallyunchanged(because permanent
earningsare unchanged)at $10.00, the P/E ratio
wouldbe 10 and 13.3 for 19xl and 19x2, whilethe
expectedP/Ein 19x3 wouldbe 10. Notethat in 19x2
there was an abnormallow earningsgrowthasso-
ciatedwitha highP/E(negativecorrelation)andthat
a high P/E in l9x2 was followedby abnormalhigh
growthin l9x3 (positive correlation).This is dis-
cussedin moredetail in W. Beaver,"The Informa-
tion Contentof the Magnitudeof UnexpectedEarn-
ings"(StanfordResearchSeminar,1974).
20. Thisconclusionis contingentuponthe waywe chose
to measurethe variablesand to rankthe portfolios.
For example,a longerterm measureof growth(i.e.,
five or 10 years)mightproducedifferentresults.
21. By unusual earningsopportunitieswe essentially
meanopportunitiesto earna returnon futureinvest-
ments greaterthan the cost of capital. Valuation
theorytellsus thatthisformof futureearningsgrowth
will inducea growthpremiumin the P/E.Notethatit
is crucialto distinguishbetweenunusualearningsop-
portunitieson future, ratherthan current,invest-
ment. To the extent there are abnormalreturns
earnedon the currentinvestment,this will not affect
the P/E ratio, althoughthe ratioof marketpriceto
book valueper sharewouldbe affected.
22. For example,if one believesthat productand factor
marketsare reasonablycompetitive,then thereexist
little or no unusualearningsopportunitiesand the
observedgrowthdifferencesare almostentirelydue
to transitoryfactors.
23. Operationally, the market-wideP/Ewasdefinedto be
the medianP/E as reportedin Table 1.
24. Althoughnot reportedhere,the analysisof the serial
correlationin P/E behaviorwas augmentedby an
analysisof a transitionmatrix.Thisanalysisalso con-
firmedthe lack of any materialtendencyto move
fromone extremeportfolioto extremeportfoliosat
the otherend of the P/E spectrum.
25. Sinceour studyis concernedwithdifferencesacross
P/Eratiosat a givenpointin time,beta(bi)willbe the
sole determinantof differencesin P/E resultingfrom
differencesin ri. Assuminga finite growthhorizon,
Litzenbergerand Rao ("Estimatesof the Marginal
Rateof TimePreferenceand AverageRisk Aversion
FINANCIALANALYSTS JOURNAL / JULY-AUGUST 1978 a 75
 of Investorsin ElectricUtilityShares:1960-66,"The
Bell Journal of Economics and Management
Science (Spring1971),pp. 265-277) haveshownthe
E/P ratio (the reciprocalof P/E) is a simplelinear
functionof beta and a growthvariable,withthe fol-
lowingform:
l=Yo+ 'Ylbl=Y2f(g)
Pi
The signof yI is expectedto vary,f(g) is somefunc-
tionof growthandY2is expectedto be negative.
26. An analysisof the residualsindicatedthat they are
well approximatedby normality.This is not sur-
prising in the sense that each observationis an
"average"for a portfolioof stocks. By the Central
LimitTheorem,we wouldexpectthe samplingdistri-
butions of averagesto approachnormality.Note,
however,that the resultsfromany one year'sregres-
sion are not independentof those of otheryears.
27. Twoapproachesimmediately cometo mind-the ap-
plicationof Box-Jenkinstechniquesto the pastearn-
ingsseriesor the useof analysts'forecastsof earnings.
Eithermethodmightproducebetterassessmentsof
expectedearningsper share.
28. This ordinalstatementholds for both depreciation
and inventory,even thoughinventoryalso impliesa
"real"differencedueto taxes.Obviously,the specific
adjustments to be madewouldhaveto distinguishbe-
tween accountingdifferencesthat implytax differ-
encesversusthose that do not.
29. W. Beaver and R. Dukes, "Delta-Depreciation
Methods: Some EmpiricalResults," Accounting
Review (April 1972), pp. 320-332. In this study,all
samplefirmswere using an acceleratedmethodfor
tax purposes.Thereforethe differencewassolelydue
to the depreciationmethodused for annualreport
purposes.
30. Anotherapproachwould be to introducevariables
relatedto the accountingeffect. Recent works by
Wattsand Zimmerman("Towarda PositiveTheory
of the Determination of AccountingStandards," Ac-
counting Review (April 1978) ) suggestthatconser-
vativenessof accountingmethod varies positively
withfirmsize.Van Breda("ThePredictionof Corpo-
rate Earnings"(StanfordUniversity,1976)) indi-
catesthataverageageof assetsis one of the variables
thatexplainscross-sectionaldifferencesin returnon
equity(i.e., earningsavailableto commondividend
by the book valueof commonequity).

recommendations, issuedon Novem- aspectsof the new AICPAself-regu-

Securities
and Regulation
continuedfrompage 38
"... the Metcalf hearings conveyed one
verydefiniteand clearmessage- a sense
of expectationandurgencyforthe profes-
sion and, as necessary,the Commission,
to act to buildthe public'sconfidencein
the independenceof accountants,in their
resolveand abilityto engagein meaning-
ful self-discipline,and in the processby
which accountingstandardsare estab-
lished.
"I have very little desire to preside,
duringmy five years as Chairman,over
increasedregulationof the accounting
profession.Similarly,I have no wish to
see legislationpassedthatwouldplacethe
responsibilityon the Commission-or
some other governmentbody-to regu-
late accountants.Nevertheless,time is
rapidlyrunningout on the opportunity
for voluntaryinitiatives."
In fact, the Metcalf Subcommittee's
ber 14, 1977, involvedmuchless far- latory program.Although Moss is
reachingfederalinterventionthanthe rumoredto be on the vergeof intro-
January 1977 staff report recom- ducing a new bill, he has indicated
mended.The subcommitteereporton that he wouldnot seek re-election.
"Improvingthe Accountability of
Publicly-OwnedCorporationsand AICPA Actions
their Auditors"recommendedcon- In September1977, the Councilof
tinuedemphasison self-regulationfor the AICPA adopted a proposal to
accountantsand the establishmentof create a new division of CPA firms
a self-regulatoryorganization,possi- thatwouldcomprisetwosectionswith
bly withmandatorymembership, sub- voluntary firm membership-the
jectto SECoversight.The reportcon- SEC Practicesection,for CPA firms
cludedthatthe accountingprofession whoseclientsareSECregistrants, and
and the SEC should"act in a timely the PrivateCompaniesPracticesec-
mannerto implementthe policygoals tion, for firmsservingcompaniesnot
in this report." registeredwith the SEC. (A firm
However, Representative Moss, could be a memberof both sections.)
Chairmanof the House Subcom- Each section would be administered
mittee on Oversightand Investiga- by a 21-memberexecutivecommittee.
tions, speakingin earlyMarch1978, A five-memberPublic Oversight
warnedthe accountingprofessionthat Boardwill havepowerto monitorac-
he would seek legislationto impose tivities of the SEC Practicesection
federalregulationof accountantsun- and report its findings publicly. It
less the accounting profession im- could also imposesanctionssuch as
proved its self-regulatory efforts. requiringa firm to take internalac-
Moss seemedparticularlyconcerned tion to improveits controlsor opera-
about the possible anti-competitive concludedon page85

1978
ANALYSTSJOURNAL/ JULY-AUGUST
76 O FINANCIAL