Abstract
The earnings-price ratio is believed to capture the market’s assessment of the equity’s risk and earnings growth prospects. Prior research, however, has found that neither risk nor growth can explain persisting cross-sectional differences in earnings-price ratios. This paper shows that persisting cross-sectional differences in forecasted long-term earnings growth are the dominant source of variation in earnings-price ratios, and that the conclusions of prior research were due to the use of realized growth as a proxy for forecasted growth, since the two measures are not highly correlated. Other factors, such as risk (beta), forecasted short-term growth, and accounting method seem to be relatively less important in determining earnings-price ratios.
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