Question

Suppose that you wanted to test the efficiency of the market in establishing Price Earnings ratios for firms. In other words, you want to examine whether Low PE stocks perform differently than high PE stocks on a risk adjusted basis over time. Provide a step by step methodology that you could follow to examine this issue. Specifically, adapt the methodology described for assessing whether the market prices firms of different size efficiently as explained in the lecture notes (Size Effect) to examining the PE effect.

Answer 1

Methodology for following the examination of the issue--

A. We will determine the price to earning ratio of the industry as a whole

B. We will put a certain market capitalisation as a matrix to determine whether a company is a small or large

C. when we will try to find the price to earning ratio of the small company in respect to price to earning ratio of the charge company

D. then we will compare the price to earning ratio of both the groups specifically

E. Then we will try to find out the relationship between performance of both the groups and if the side effect can be visible than Efficient market hypothesis will be completely violated

Efficient market hypothesis believes that nobody can make exess return because all the information are discounted and hence in this case if the relationships can be established then it will lead to violation of Efficient market