The Relationship Between Price Earnings Ratio and Stock Returns of Companies Listed at the Nairobi Securities Exchange

Abstract

The main objective of this study was to examine the relationship between price earnings ratio and stock returns for companies listed at the Nairobi Securities Exchange. For this purpose secondary data obtained from the annual reports and financial statements of 61 companies listed at the NSE for the period January 2009 to December 2013 was analyzed. A regression model was used to establish the relationship between price earnings ratio and stock returns, variables were price earnings ratio, market to book value ratio and size of the firms as measured by total assets. Tests of significance were carried out for all variables using t-test at 95% level of significance. The model examined in this study gave a coefficient of determination (R2) of 35.6% and all the independent variables are positively related to the stock return. The study concluded there is a significant relationship between price earnings ratio and stock returns for companies listed at the NSE, majority of the firms had low P/E ratios resulting in higher stock returns, that firms with lower reinvestment needs have higher price earnings ratios than firms with higher reinvestment rates, that stocks with high market to book value ratios have significantly higher returns than stocks with low market to book values ratios and that there is a significant relationship between total assets and stock returns of firms. It is important to note that many other factors for example interest rates and industry performance affect stock returns and investors should consider them when making investment decisions. The study recommends that due to the importance of price earnings ratios in investment decisions, care should be exercised in determining what the correct and comparable earnings per share of each company , that there is need for investors to carefully use market to book ratio to determine the differentials between net assets of the firm and the valuation that the market assigns to them as it reflects the premium (or discount) that the market gives to the firm on its net assets and, as such, reflects the efficiency with which the market views the firm as being managed which in turn affect stock returns.