firms, such as JDS Uniphase and AOL, that took huge write-offs related
to overpriced stocks that were purchased at the height of the bubble.P-E Ratios and Future Stock Returns
Although the P-E ratio can be a misleading indicator of future stock re-
turns in the short run, in the long run the P-E ratio is a very useful pre-
dictor. The reasons may be understood by analyzing how stock and
bond returns are calculated.
Thecurrent yieldof a bond is the ratio of the interest received over
the price paid, and it is a good measure of future return if the bond is not
selling at a large premium or discount to its maturity value. A similar
computation can be made with stocks by computing the earnings yield,
which is the earnings per share divided by the price. The earnings yieldCHAPTER 7 Stocks: Sources and Measures of Market Value 111
FIGURE 7-2
Historical P-E Ratios Based on the Last 12 Months of Reported Earnings, 1871 through December 2006