An evaluation of price to earnings and price to book values as predictors of stock returns of firms listed at the Nairobi Stock Exchange (NSE)

Abstract

This research provides a test on the extent of predictive ability of price to earnings and price to book value ratios in the Nairobi stock market to determine future share returns. The use of PIE and PIB ratios as forecasting variable is examined using Nairobi Stock Exchange (NSE) data from 1998 to 2002.The study mirrors studies done earlier by Black (1980) ,Liu, et al (2007) and Block (1995) among other researchers which are in agreement on the importance of market valuation multiples. The data used in this research was collected from Nairobi Stock Exchange daily stock prices for the period 1998 to 2007 from which the yearly returns were compiled .

Earnings and Book values were also obtained from NSE.The study focused on two portfolios of the firms: those which had higher PIE and PIB ratios and those that had lower PIE and PIB ratios during the preceding period i.e. 1998 to 2002.The firms which had median PIE and PIB ratio were dropped. The returns for the subsequent five years 2003 to 2007 were used to evaluate the predictive power of the two valuation multiple. A qualitative analysis was conducted by use of paired T -tests to confirm whether there was significant difference between the average returns for the two types of portfolios.

The conclusions drawn from the research were that the portfolio for firms with low PIE and PIB ratios performed significantly better by achieving higher returns than the portfolio for firms with high PIE and PIB ratios. Portfolio with low PIE performed best then followed by portfolio with low PIS ratio. Coefficient of variation was used to measure performance and it turned out that portfolio with low PIE' had lower coefficient of variation, followed by low PIB portfolio.

The worst performers were portfolio with high PIB and PIE ratios. Since many studies have continued to point at the importance of these valuation multiples in measurement or predicting stock returns, it is important that the policy and decision makers' needs to regulate the process of production of financial information so that they show accurate and correct data which analysts and other users may rely on. It is important to enforce provision of accurate information which may be useful to users of financial information. Investors and market players should be encouraged to use these valuation multiples and results could be compared with other valuation measures such as Discounted Cash flow Techniques.