Question

4. You analyzed the returns of a sample of stocks. You found that, on average, the firms with high earnings to price (E/P) ratios have higher subsequent returns. (iii) If mispricing is the primary reason for this pattern in E/P ratios, what long-short trading strategy will you propose? Justify your proposed strategy (Approximately three sentences)

Answer 1

Stocks with higher Earnings to Price (E/P) ratio signifies that these stocks have better earnings per share compared to its peers and at the same time stock price is lower than its peer companies. Such stocks are considered to be undervalued.

Stocks with higher E/P ratio are cheaper than those with lower E/P.

Since, mispricing is the primary reason, appropriate strategy in such case would be to Long / Buy these stocks.

Subsequently, Sell these stocks in future when the stock price increases.