The Relationship Between Price Earning Ratio and Stock Returns of Companies Listed at the Nairobi Securities Exchange
Abstract
This study sought to establish the relationship between stock returns and price earnings ratio for
firms listed at the Nairobi Security Exchange. While the effect of price earnings ratio has been
extensively examined in developed markets, studies in developing markets are notably limited.
The study used a descriptive research design. A census targeting the sixty companies listed
between 2009 and 2013 was conducted. The study used secondary data obtained from the
Nairobi Securities Exchange handbook. Data was collected for forty firms that were continually
listed over the period cover by the study. The relationship between stock returns and price
earnings ratio was evaluated by conducting regression analysis. Two regression models were
constructed one in which stock returns were regressed against the price earnings ratio and the
other in which returns were regressed against the price earnings ratio and book to market ratio
with the latter being used as a control variable for size. In both regressions the coefficient of
price earnings ratio was found to be positive. This means that there existed a positive relationship
between stock returns and price earnings ratio. However the relationship was found to be not
significant. The results of the study revealed that in both regressions the coefficient of
determination was very low. This means that a very low percentage change in stock returns was
explained by variation in price earnings ratio both individually or together with book to market
ratio. The study concluded that there existed a positive relationship between stock returns and
price earnings ratio at the Nairobi Securities Exchange but the relationship is not statistically
significant. Investors may not find it useful in selecting investment stocks on the basis of their
price earnings ratio since stock returns bears insignificant relationship with price earnings ratio at
the Nairobi Securities Exchange. Further studies may explore whether portfolios formed of
stocks with low price earnings ratio perform better than a portfolio formed of high price earnings
ratio on a risk adjusted basis. Also further studies may seek to use earnings yield rather than
price earnings ratio in order to avoid omitting stocks whose price earnings ratio is negative