The Effect of Growth of Earnings and Stock Prices on the Price - Earnings Ratio of Firms Listed at the Nairobi Securities Exchange

Abstract

The objective of the study was to establish the effect of the growth of earnings and the growth of stock prices on the price earnings ratio of companies listed at the Nairobi Securities Exchange (NSE). The study adopted a descriptive survey design. It involved a census survey of all the companies listed at the NSE during the years 2003 – 2012. These were subdivided into 10 subsets corresponding to the 10 sectors of the Exchange. Secondary data was obtained from the NSE Handbooks covering the periods 2002 – 2006, 2003 – 2007 and 2008 – 2012 which provided 5-Year company financial performance summaries. The data collected was summarized into yearly weighted averages for the test variables for the NSE for the years 2003 – 2012. This summary data was then analyzed using descriptive statistics. Multivariate correlation and regression analyses were used to test the relationship between the price earnings ratio and the growth of earnings and stock prices. The study found that there existed a moderate but positive association between the price earnings ratio and the growth of stock prices, but an insignificant relationship between the price earnings ratio and the growth of earnings. However, it found a moderate to strong positive association between the growth in the price earnings ratio and the growth in stock prices, and a moderate and negative association between the growth in price earnings ratio and the weighted average annual riskless rate (the 91-day T-Bill rate). The association between the growth in price earnings ratio and the growth in earnings was not insignificant. The study found that these associations were more pronounced for shorter periods, i.e. 2003 – 2007 and 2008 – 2012, than for the entire 10 year period, and more pronounced for 2008 – 20012 than for 2003 – 2007.The study concluded that the associations determined for the NSE reflected similar empirical studies of other exchanges, and they also suggested a an efficient market in the weak form, with growth rather than value shares dominating the exchange. The study recommends reform of the NSE to move it to an efficient market in the semi-strong to strong form. It also suggests that further research be undertaken using more refined data to authenticate these findings. Key words: price earnings ratio, stock prices, earnings, riskless rate.