The Relationship Between Price Earning Ratio and Stock Return of Firms Listed at the Nairobi Securities Exchange

Abstract

Economists as well as investors have examined anomalies on the stock exchange around the world for decades. There are enough empirical studies that show that both practical people and investment analysts use the Price Earnings ratio as a variable to make their investment decisions. These studies analyze whether a security is overvalued or undervalued. This anomaly is called the price earnings effect. This study sought to establish whether there is a relationship between the P/E ratio and stock returns at the Nairobi Securities Exchange. The P/E ratio of the listed stocks in the Nairobi Securities Exchange was computed annually from 2008-2013.The companies yearly return was calculated for the same period. To examine if there existed a Price Earning effect, the share return was compared to the Price Earnings ratio to determine if there was a significant difference in return. After careful analysis of the results and conducting a t-test at a significant level of 95% with a 5% risk level, the share return proved to be statistically insignificant to the Price Earnings Ratio showing that the ratio did not influence the share return at the Kenyan securities market. This result answers the research question and verifies that a price earnings effect did not exist on the Nairobi Securities Exchange during the period 2008-2013and that it was in fact not possible to make an abnormal return using the PE ratio as the only investment strategy. The study recommended that since the data used the reported Earnings per share in the company financial statements, normalized EPS should be used as it excludes extraordinary and one off earnings items.