Another look at P / E ratios February

Price-earnings (P/E) ratios should be positively related to growth and negatively related to interest rates and risk. Whereas earlier investigations of the determinants of P/E ratios find these links to be weak, results of recent research estimating the cost of capital imply stronger links. The two sets of research employ different sets of proxies for P/E ratios (trailing vs. forward ratios), growth (observed vs. forecast growth) and risk. We update the literature investigating the determinants of P/E ratios by contrasting the results based on the two sets of proxies. We also investigate a recent finding which suggests that forward P/E ratios are negatively related to the volatility of reported earnings, even though reported earnings volatility does not appear in the relation derived for forward P/E ratios. Our results suggest an indirect connection: firms with lower earnings volatility, due to lower cash flow volatility and greater earnings smoothing due to accruals, are associated with higher growth prospects and lower risk.