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Expected P/E, Residual P/E, and Stock Return Reversal: Time-Varying Fundamentals or Investor Overreaction?

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Author Info

  • Ying Huang

    (School of Business, Manhattan College, U.S.A.)

  • Chia-Hui Tsai

    (First Taisec Capital Management, Taiwan)

  • Carl R. Chen

    (Department of Economics and Finance, University of Dayton, U.S.A.)

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    Abstract

    We decompose P/E ratios into a fundamental component and a residual component that cannot be explained by the firm or economic fundamentals. Purging the fundamental component from observed P/E ratios, we find that portfolios based on residual P/E ratios exhibit performance reversal only in overbid glamour stocks; hence over-optimism is more prevalent than over-pessimism.

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    Bibliographic Info

    Article provided by College of Business, and College of Finance, Feng Chia University, Taichung, Taiwan in its journal International Journal of Business and Economics.

    Volume (Year): 6 (2007)
    Issue (Month): 1 (April)
    Pages: 11-28

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    Handle: RePEc:ijb:journl:v:6:y:2007:i:1:p:11-28

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    Postal: 100 Wenhwa Road, Seatwen, Taichung
    Web page: http://www.ijbe.org/
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    Related research

    Keywords: P/E ratios; overreaction; market efficiency;

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    1. Partha Gangopadhyay, 1996. "Macroeconomic Variables And Seasonal Mean Reversion In Stock Returns," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 19(3), pages 395-416, 09.
    2. Basu, S, 1977. "Investment Performance of Common Stocks in Relation to Their Price-Earnings Ratios: A Test of the Efficient Market Hypothesis," Journal of Finance, American Finance Association, vol. 32(3), pages 663-82, June.
    3. Cook, Thomas J. & Rozeff, Michael S., 1984. "Size and Earnings/Price Ratio Anomalies: One Effect or Two?," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 19(04), pages 449-466, December.
    4. Banz, Rolf W., 1981. "The relationship between return and market value of common stocks," Journal of Financial Economics, Elsevier, vol. 9(1), pages 3-18, March.
    5. Fama, Eugene F & French, Kenneth R, 1995. " Size and Book-to-Market Factors in Earnings and Returns," Journal of Finance, American Finance Association, vol. 50(1), pages 131-55, March.
    6. James M. Poterba & Lawrence H. Summers, 1987. "Mean Reversion in Stock Prices: Evidence and Implications," NBER Working Papers 2343, National Bureau of Economic Research, Inc.
    7. Reinganum, Marc R., 1981. "Misspecification of capital asset pricing : Empirical anomalies based on earnings' yields and market values," Journal of Financial Economics, Elsevier, vol. 9(1), pages 19-46, March.
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