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

Abstract

This study sought to establish the relationship between stock returns and price earnings ratio for firms listed at the Nairobi Security Exchange. While the effect of price earnings ratio has been extensively examined in developed markets, studies in developing markets are notably limited. The study used a descriptive research design. A census targeting the sixty companies listed between 2009 and 2013 was conducted. The study used secondary data obtained from the Nairobi Securities Exchange handbook. Data was collected for forty firms that were continually listed over the period cover by the study. The relationship between stock returns and price earnings ratio was evaluated by conducting regression analysis. Two regression models were constructed one in which stock returns were regressed against the price earnings ratio and the other in which returns were regressed against the price earnings ratio and book to market ratio with the latter being used as a control variable for size. In both regressions the coefficient of price earnings ratio was found to be positive. This means that there existed a positive relationship between stock returns and price earnings ratio. However the relationship was found to be not significant. The results of the study revealed that in both regressions the coefficient of determination was very low. This means that a very low percentage change in stock returns was explained by variation in price earnings ratio both individually or together with book to market ratio. The study concluded that there existed a positive relationship between stock returns and price earnings ratio at the Nairobi Securities Exchange but the relationship is not statistically significant. Investors may not find it useful in selecting investment stocks on the basis of their price earnings ratio since stock returns bears insignificant relationship with price earnings ratio at the Nairobi Securities Exchange. Further studies may explore whether portfolios formed of stocks with low price earnings ratio perform better than a portfolio formed of high price earnings ratio on a risk adjusted basis. Also further studies may seek to use earnings yield rather than price earnings ratio in order to avoid omitting stocks whose price earnings ratio is negative