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Why Price Earnings Ratio (PE) matters? What Nifty PE tells right now?

Why Price Earnings Ratio (PE) matters? What Nifty PE tells right now?
Education Series | May 31, 2017

Fundamental Analysis of Nifty guides PE. PE guides the Market movement. What does Nifty PE tell about the current Market scenario?

Nifty PE ranges from 10 to 25

Many smart investors watch the Nifty PE (Price Earnings Ratio) for timing their investment in the stock market. The average P/E of the broad-based Nifty Index over last 20 years is ~18. Nifty is said to be trading in an undervalued zone if the PE at which it trades at around 10 to 15. On the other hand, Nifty is said to be trading at overvalued zone if it trades at around 20-25. And if Nifty trades at P/E ranging between 15 and 20, then it is said to be trading in its normal range.  Noticeably, the overshooting was followed by a sharp decline in index PE and the market brought it back inside the traditional range. Currently, Nifty is trading at PE of 23.7, which is why many market participants are considering it to be trading in an overvalued zone.

Now, does this signal that Nifty is overvalued and a large market correction is on the way?

Which PE to adopt- conventional Trailing PE or analyst appreciated Forward PE?

To get clarity on this, let us first understand what PE means. PE ratio is computed by dividing the market price with the company`s earnings per share. In the case of computing PE of Index, an Index value is divided by weighted average earning per share of Index constituents. A PE is usually looked from two perspectives - the Trailing PE and the Forward PE. Trailing PE implies earning per share in last four quarters while computation of Forward PE requires expected earnings per share in next four quarters.

These two ways of computing PE give widely different values and make analysis difficult for decision making. Let’s see what`s more scientific way of doing it.

When we plan to invest, we expect that market should go up in next one year. This simply means that in the current year, we try to figure out what the index will be in the future. To put it in a different way,  we try to figure out what the PE of the index will be in future i.e we try to arrive at the Forward PE in the current year which actually is the Trailing PE of the future year.

Let’s take an example: In May 2017, we wanted to invest for next one year. So, we predicted Nifty for May 2018. We needed to estimate what the trailing PE would be in May 2018. This simply means we needed to know what the Forward PE is for Nifty in May 2017.

This clarifies that when we talk about investment for future it`s more scientific to look at Forward PE that to look at Trailing PE of the Index.

Again, a study of Forward PE chart reveals that historical Forward PE has also oscillated between the above-mentioned range of 10-25 with a few overshooting in 2000 and 2008 followed by sharp declines in bringing back the PE inside the range. The Average Forward PE of last 17 years that comes out to be 17 is considered as fair value Forward PE of the Market for forecasting purpose.

Forward PE depends on projected EPS growth

Correct computation of Forward PE is required to rightly forecast, say for next one year movement in the index. Interestingly, at times, what appears cheap might be costly or what appears costly might be cheap, depending on whether we are rightly computing the future EPS.

For arriving at what the Forward PE of the index would be, it is imperative to calculate the Forward EPS of the index. And that requires anticipating the growth in EPS of Nifty (detailed computation needs to anticipate the growth rightly in EPS of all the Nifty constituents). So, the NIFTY Forward EPS is historical EPS plus expected growth EPS in next one year. And as historical EPS is already a known variable, what remains critical here is what will be our growth assumption for next one year.

The sensitivity of Nifty PE with expected growth:
See the table below:

Right now, whether we are at Nifty PE of 25.3 or at a much attractive PE of 17.5, it depends on our growth assumption. An error in correctly estimating growth is a critical mistake that people often commit while analyzing the market on the basis of PE.

Presently, consensus estimates that Nifty EPS growth is 18%, based on which the Forward PE is 18. Our fundamental research team has their estimates at 14% that implies present Nifty PE to be at 19.

Lastly, we must note here that PE is just one of the ways to understand the market future. Market movement depends on various other factors, such as sales growth, changes in net profit margins,  free cash flow yield and return on equity. Also, it`s worth noting that larger market peaks like that of 2008 takes place when we are at the peak of PE and also net profit margin.

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Atul MishraAdvanced Market

Atul works with an Advanced Market Research Group at Narnolia Research. His forte is quantitative research on Indian equities. He is a computer science graduate with Masters in Finance from Faculty of Management Studies, Banaras Hindu University.

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