THE USEFULNESS OF RATIO ANALYSIS IN PREDICTING STOCK MARKET RETURNS

There is much debate over the ability of firms to earn an above-normal return using either rules of investing or ratio analysis. If the capital markets are weak-form efficient then the market will already have reacted to the past information embodied in financial ratios. Theoretically, if the average investor responds irrationally to past information, arbitrageurs would short those stocks that are over-priced and buy those that are undervalued pushing over-priced shares down and under-priced shares up. Therefore, if capital markets are always weak-form efficient, one should not be able to predict return or change in stock price using financial ratios, because the price of a stock should already reflect the information in those ratio's. If the stock returns can be predicted using financial ratios, investors could use that information to make greater profit than the market as a whole. RESEARCH PROBLEM Though some researchers believe that the markets are efficient enough to render ratio analysis useless, there is some evidence that markets may not always be efficient and that ratio's can help predict returns. The set of ratio's that may be useful for this purpose include B/M (book to market), P/E (price to earnings), and DY(dividend yield). It would be valuable to any investor t