Studies of firms classified on the basis of P/E ratios come to the conclusion that low-P/E-ratio stocks earn much higher returns,after adjusting for risk,than high-P/E-ratio stocks.This is because
A) low-P/E-ratio stocks are riskier than high-P/E-ratio stocks.
B) investors like low-P/E-ratio stocks.
C) low-P/E-ratio stocks are more likely to be undervalued.

Question

Quizplus · Accepted Answer

Studies suggest that the primary reason for low-P/E-ratio stocks to earn higher returns, after adjusting for risk, than high-P/E-ratio stocks is that they are more likely to be undervalued. The market may have overlooked these stocks or underestimated their future earnings potential, leading to a lower P/E ratio. As a result, as the market corrects its mistakes and realizes the true value of these stocks, their share prices tend to increase, setting the stage for higher returns.

Studies of Firms Classified on the Basis of P/E Ratios