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Financial Analytics: Science and Experience
 

Analyzing the return on equity based on the price-to-earnings ratio

Vol. 15, Iss. 1, MARCH 2022

Received: 8 November 2021

Received in revised form: 17 November 2021

Accepted: 28 November 2021

Available online: 28 February 2022

Subject Heading: FINANCIAL INSTRUMENTS

JEL Classification: C51, E31, G12, G17

Pages: 65–79

https://doi.org/10.24891/fa.15.1.65

Subject. The article addresses the dependence of return on equity on the price-to earnings ratio and anticipated inflation.
Objectives. The purpose is to determine the type and parameters of such a dependence.
Methods. The study draws on the share valuation method and regression analysis, to determine the parameters of the proposed model.
Results. The paper shows that for the US stock market (S&P 500 index), return on equity substantially depends on estimated price-to-earnings ratio based on the 10-year average profit at the beginning of the ownership period, and on the indicator chosen to characterize the expected inflation at the end of the ownership period. It provides an algorithm of practical use of the model to estimate the maximum allowable value of inflation parameter at the end of ownership period, which enables to obtain the required yield with a given probability. For the ownership period of 2020–2030, I built the estimated dependence of anticipated profitability on changes in the indicator of expected inflation relative to the value at the end of 2020.
Conclusions. The study offers a model for estimating the average return on equity based on the price-to-earnings ratio and defines its parameters. The adequacy of the model for the US stock market has been empirically confirmed. The findings may complement the set of decision-making tools for investors in the stock market.

Keywords: stock market, price-to-earnings ratio, inflation, stock returns, stock return factor

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