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Relationship between Price–Earnings Ratios and Stock Value in an Emerging Market

In this article, an attempt was made to determine whether price–earnings (P/E) ratio indicates future prices or yields in Indian capital market. While the efficient market hypothesis negates the possibility of prediction, the P/E ratio supporters argue that due to exaggerated investors’ expectations, P/E ratio may indicate future investment performance. Four major indexes of the Bombay Stock Exchange (BSE) are chosen for the investigation: the S&P BSE SENSEX, S&P BSE 500, S&P BSE MID CAP and S&P BSE SMALL CAP. Using vector error correction model (VECM) and vector autoregression (VAR) estimations, I find that subsequent prices will increase and subsequent yields will decline in response to an increase in the P/E ratio. But the prediction only works with blue-chip firms or firms with large market capitalization and not for mid-size firms or small-size firms. The impact on subsequent yield is very weak even for large-size firms.