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Does investor sentiment affect price-earnings ratios?

Boonlert Jitmaneeroj (School of Business, University of the Thai Chamber of Commerce, Bangkok, Thailand)

Studies in Economics and Finance

ISSN: 1086-7376

Article publication date: 5 June 2017

Abstract

Purpose

A large number of empirical studies investigate the determinants of price-earnings (P/E) ratio by focusing on fundamental factors. However, there has been an increasing concern that stock valuation is also driven by investor sentiment. This paper aims to extend the existing literature by exploring whether investor sentiment impacts the P/E ratio.

Design/methodology/approach

The paper examines the determinants of P/E ratio by applying latent variable models with investor sentiment as a latent variable and several fundamental factors as control variables. Investor sentiment is proxied by trading volume, advance-decline ratio and price volatility.

Findings

Using annual data of the US industries over the period of 1998-2014, the current paper produces new empirical evidence that investor sentiment significantly affects the P/E ratio. This result is robust to the inclusion of several control variables that have been documented to explain the P/E ratio.

Practical implications

The findings have important implications for investors, as downplaying sentiment can lead to significant errors in making equity investment choices based on the P/E ratio.

Originality/value

The analytical framework of the current paper is differentiated from the conventional analysis in which the P/E ratio is regressed against control variables and proxies for sentiment, thus falling into the trap of implicitly presupposing that proxies are perfect measures of investor sentiment. As all proxies may have measurement errors to the true but unobservable investor sentiment, the current paper uses latent variable models to shed new light on the influence of investor sentiment on the P/E ratio.

Keywords

Acknowledgements

The author would like to thank the editor and anonymous referees for helpful comments, Aswath Damodaran for the data set, Essex Business School for research resources and the University of the Thai Chamber of Commerce for research funding.

Citation

Jitmaneeroj, B. (2017), "Does investor sentiment affect price-earnings ratios?", Studies in Economics and Finance, Vol. 34 No. 2, pp. 183-193. https://doi.org/10.1108/SEF-09-2015-0229

Publisher

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Emerald Publishing Limited

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