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

In this paper an attempt was made to determine whether Price-Earnings (P/E) ratios indicate 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 Bombay Stock Exchange 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 Auto Regression (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