The P/E Ratio And Profitability

Abstract

This paper examines the relation between the forward price-to-earnings (P/E) ratio and profitability. Consistent with the theoretical predictions of Ohlson and Zhan (2006), this paper finds a U-shaped relation between the forward P/E ratio and return on equity (ROE). Besides, firms with high P/E ratios tend to have lower ROE in the subsequent years, and their ROE is very volatile and wide-distributed. Using the GSCORE from Mohanram (2005), this paper separates winners from losers among high P/E firms. Firms with high GSCORE yield higher earnings growth, sale growth, ROE, and excess stock returns in the following years.