Academic journal article The International Journal of Business and Finance Research

International Earnings to Price Ratio Convergence: Evidence from the European Union

Academic journal article The International Journal of Business and Finance Research

International Earnings to Price Ratio Convergence: Evidence from the European Union

Article excerpt

ABSTRACT

This paper investigates whether any pattern of convergence of international earnings-to-price ratios that exist for a sample of 19 European Union (EU) countries over the period 1994-2012 can be detected through the methodology of Phillips and Sul (2007). This methodology is based on a general form of a nonlinear time varying factor model and allows for cross sectional heterogeneity as well as for different transitional time paths towards equilibrium. The results show that such a convergence is not present. Next, the study aims at detecting any potential factors supporting the pattern of divergence. The empirical findings reveal that such divergence patterns mainly reflect divergence in economic factors.

JEL: G10, C23

KEYWORDS: Earnings-Price Ratios; Club Convergence; Clustering Procedure; European Markets

(ProQuest: ... denotes formulae omitted.)

INTRODUCTION

Price-earnings ratios measure the willingness of investors to pay for current earnings. They are used either as a valuation tool for assessing stocks vis-à-vis other stocks in terms of growth and risk or determinants in cost-of-capital computations. Bekaert (1995) argues that higher price-earnings ratios imply a stronger degree of market convergence. These ratios have also been widely used as indicators for the quality of investments (Dontoh et al., 1993) as well as indicators of convergent markets. In the case that expected returns from various markets depend on location, they are characterized as segmented (Karolyi and Stulz, 2002). In addition, the P/E ratio has been considered an indicator of transitory earnings, future earnings or risk. If investors' information sets are not homogeneous, low P/E ratios may signal undervalued stocks and portfolios of low P/E stocks should yield excess returns even after they are adjusted for risk. Even assuming non-homogeneous information sets, the hypothesis that all market agents evaluate the price stocks according to a discounted cash flow approach is still a useful benchmark, which can be tested and rejected in favor of alternative hypotheses. Its implications are that the expected growth of earnings and payout (risk and persistence) should be negatively (positively) related to the earning price ratio.

Benefits of market convergence include lower volatility and an increased ability to absorb shocks. In convergent markets the cost of equity capital diminishes, which in turn boosts investments, and accordingly, economic growth. Colacito and Croce (2010) argue that in convergent markets, shocks are at least partially diversifiable across countries. They conclude that the implied benefits of keeping international financial markets open can be as high as ten percent of lifetime consumption. Similarly, Umutlu et al. (2010) demonstrate that increased market convergence results in lower volatility and an increased ability of global markets to absorb risk. Possible costs, or downside effects, of market convergence include fewer diversification benefits and increased chance of a joint crash across markets. Financial markets that are at least partially convergent place less weight on local risk factors (Carrieri et al., 2007). This may lead to fewer diversification benefits, which might lead to slower stock price gains (Eun and Lee, 2010). Beine et al. (2010) find that financial liberalization increases co-movements between markets most strongly during crashes, implying that increased openness in markets increases the likelihood of a joint crash across all markets.

The objective of this paper is, first, to investigate whether earnings-to-price ratios from 19 European Union (EU) countries have been converging over the recent years, and second, if such convergence or divergence patterns can be documented, it is the role of macroeconomic factors that can explain them. The overall related literature acknowledges that EU positive earnings stocks have a P/E ratio around 25, while the expected 1-year ahead rate of growth is highly volatile. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.