Is China's P/E ratio too low? Examining the role of earnings volatility

We find that China's P/E ratio is comparable to that of the U.S. S&P 1500 index, a broad based index covering large, middle, and small capitalization firms. We provide an explanation as to why China's seemingly low P/E ratio is not surprising in light of the economic growth that it has experienced. Specifically, we show that (i) the P/E ratio is negatively associated with earnings volatility in both the Chinese and U.S. stock markets with an economically significant magnitude; and (ii) historical earnings volatility is considerably higher in China than in the U.S. Higher earnings volatility in China offsets higher growth prospect in setting the P/E ratio, making its P/E ratio much closer to what is observed empirically than otherwise implied by its growth rate.

► China and U.S. have similar P/E ratio despite China’s economic growth.
► Earnings volatility is negatively related to P/E.
► China’s earnings volatility is much higher than that of U.S.
► China’s P/E is also more sensitive to earnings volatility.
► Earnings volatility offsets growth in setting P/E.