Question

An investment strategy that seeks to create a portfolio of stocks with low price-earnings ratios is believed to be able to earn excess market returns. Explain why this is not the case in a perfect capital market under certainty.

Answer 1

Solution:

Price to earning ratio is one of the tool to identify the undervalued or overvalued. If the stock has low PE ratio than average then we say that the stock is undervalued and will appreciate in future. When we create the portfolio with low PE ratio stocks then in normal condition we can believe that the portfolio will give better return than the market and there will be excess market return.

But in perfect capital market the stock price already factors all the information. If any stock has low price-earning ratio then it does not means that the stock is undervalued. The price of the stock is low because this is the value this stock should fundamentally have. Since in perfect capital market all the information are readily available and price adjusted quickly and there is no scope for arbitrage. Hence in perfect capital market generating excess market return is not feasible.