Explanatory Factors for Market Multiples and Expected Returns

Market multiples of the largest firms are most likely to reflect efficient pricing of stocks. For such firms, variations in market multiples should be largely explained by fundamental variables, and expected returns should be positively related to beta but not significantly related to other factors. This study shows that, for stocks in the Standard & Poor’s 100 index, fundamental factors explain almost all of the variations in price/book and price/sales multiples but only 25% of variations in forward price/earnings multiples. Expected returns are positively related to beta, as postulated by the capital asset pricing model. However, contrary to the expectations of the capital asset pricing model and the weak and semistrong forms of the efficient market hypothesis, expected returns are also significantly negatively related to prior returns and forward price/earnings multiples. These findings are surprising for a sample comprising the largest stocks.