In the EMH section, it says that firms with low P/E ratio outperforms high P/E ratio firm. In the stock valuation, it says that firm with higher earning growth rate have higher P/E ratio than slower growing firm. Do those two statements contradict each other??? If a firm is a high growth firm, then it’d outperform slower-growth firm correct? But EMH says otherwise.
No they don’t contradict each other. Investors bid the prices of firms with high earnings growth rates, making their P/E’s high, i.e., they are becoming ovebought. Firms with low P/E’s have been studied to see if they would outperform firms with high P/E’s. Some studies found them to outperform. If that is true, then that casts doubt on the validity of the EMH. However, none of this is absoultely true, which makes EMH still debatable.
This does not necessarily mean that EMH doesn’t hold. The most common explanation is that it is a risk story (in a EMH framework). It makes sense that a firm that has consistent and growing profits (high P/E) is less risky than a firm that is on the brink of bankruptcy (low P/E firm). Imagine if these two firms went to a bank to get a loan. Who would pay more for their capital? The low P/E firm for sure. This is the same thing that happens with their stock. Because the low P/E firm is more risky they must pay more for their capital. This comes in the form higher expected equity returns (market sorts it out). Of course the other side of the debate is that markets aren’t efficient. This leads to explanations based on behavioral finance (among maybe a hundred others). As Dreary points out this is a highly debated subject.
thx guys… i hope i can soak these info into me at this point…