Unsurprisingly when P/E ratios and dividend yields reach extreme levels, stock prices usually revert back to a normal level or a longer-term mean. The question is whether this is due to a change in the financial situation of a company or a change in stock price. In other words, can P/E ratios and dividend yields work as a good predictor of price?
Conventional efficient market theory holds that stock prices are not predictable. That would imply that since extreme P/E’s and dividend yields revert back to the mean, it would have to be earnings and dividend which changes to cause this. Unfortunately, the data supports just the opposite: extreme P/E’s and dividend yields revert back to the mean due to a change in price.
P/E ratios are used to gauge whether shares look expensive or cheap by comparing prices to earnings. The theory is that you shouldn’t mind paying higher prices as long as you also get higher earnings or profit. It’s calculated by dividing the share price by the earnings per share. The P/E ratio of the Australian market is 15.3 at the moment.
High dividend yields are either because of increasing dividends or because of falling share prices. A dividend yield is calculated by taking the full year dividend, dividing it by the share price and multiplying by 100 to turn it into a percentage. The yield on the market is 4.1% at the moment.
Predictive ability of P/E and dividend yields
“Valuation Ratios and the Long Run Stock Market Outlook” by John Y, Campbell and Robert J, Shiller examines the US market and whether P/E ratios and dividend yields have any predictive ability.
In looking at data from 1872-1998 for the S&P 500, the historical P/E ratio is 14.2 with a range usually between 8-20 and an extreme high of 26. Dividend yield saw an average of 4.73%, a range of 3-7% and an extreme high of 10%.
Extreme ratios do predict price changes
So, what this shows is that extreme levels in ratios tended to be a predictor of price movements rather than any changes that may have taken place with the financial situation of a company.
The study also showed that dividend yields were a poor predictor of changes in dividend payments. For example, if a company had a high dividend yield, that did not mean there would be a cut in dividends.
In the same way, P/E ratios also tended to be poor predictors of earnings. So just because a company had a high P/E ratio, it did not mean there would be high earnings. Rather, a high P/E ratio usually predicted a fall in stock price which would bring P/E’s back to a more normal level
What you can do
Of course, this study was not done on individual stocks but on the sharemarket as a whole. What is true for the whole may not be true for its parts.
So, if you’re a trader who likes to incorporate fundamentals into your trading strategy, you should pay attention to the warnings when the sharemarket has a high P/E valuations. That’s because it usually signals that there will be a fall in the share prices rather than a rise in earnings.
And if you’re noticing high dividend yields for stock you’re interested in, this will often signal a bargain buy rather than a cut in dividends.