PEG ratios and stock returns.

Description

The thesis examines the explanatory power of the PEG ratio in the cross section of stock returns. The PEG ratio is defined as the P/E multiple of a stock divided by its expected long-term earnings growth rate. It is postulated that the PEG ratio to a large extent captures investors' expectational errors embedded in stock prices. The conventional wisdom is that stocks with very low (high) PEG ratios are underpriced (overpriced), so PEG ratios are negatively related to stock returns. The evidence of regression analysis for individual firms supports this claim. However, the relation between PEG ratios and returns on PEG portfolios is not monotonically decreasing---the regression analysis provides insufficient account for observations with extremely low PEG ratios. Both low- and high-PEG stocks earn lower average returns than stocks with medium PEG. The pricing errors associated with stocks of extreme-valued PEG cannot be eliminated by traditional risk-adjustment procedures. The large pricing errors on low- and high-PEG stocks are attributed to unusually large biases in analysts' forecasts. Analysts and hence investors are overly optimistic in interpreting prior earnings information. This results in larger-than-average earnings disappointments, and consequently lower-than-average returns, on stocks with low or high PEG ratios.

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