India Fund Performance Compared to Index -Sensex(in %)
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Wednesday, July 15, 2009

Index P/E Ratio and its importance

Here we are looking at the index P/E ratio and its possible use while making investment decisions. I have taken the data from Indian index (Sensex), we should be able to do similar analysis for any of the indexes.

Following chart is based on P/E ratio of Sensex from Jan 1995 to Jun 2009. Index values as such cannot be used to compare with historic data, but since P/E is a ratio, we can compare P/E with historic P/E data.

Few things to notice:
- The P/E ratio has a normal range which seems to be between 15-25.
- Every time the ratio crossed above 25, it was short and lead to a sharp fall in market.
- Every time the ratio crossed below 15, it was poised for a rise.
- Earnings ('E' in P/E), because it can be manipulated is not considered to be a very reliable number for analysis which makes P/E ratio not the best ratio to use. But when taken on a collective basis like in Index, it may offer a better indicator.
- When P/E is above 25, it does not matter if you are holding an undervalued, growth or any other type of stock, all stocks were hit sharply. Best thing at this point may be to consider selling.
- Individual company analysis is important, but factoring in the market condition based on this historic data may help.
- This indicator may be worth looking into especially when the current ratio is outside the normal range.
- Over a long duration of time, there may be changes in the what we consider 'normal range'.
- Index can go up without affecting the P/E, if there is a corresponding increase in the earnings.

- Notice that currently market P/E is around (as of Jul/15/2009): 18.52.

I will be publishing the current P/E data periodically on the site (right side) in 'Indexo Meter' graph.


Lucky said...

It is but sensible not to ignore the bigger picture. So unless there is a stock which one is going to stick with for 10+ years (and maybe even for that), it is a better idea to sell at Sensex/Nifty P/E of 22-25.

Rohit has a nice (safer) article which talks about buying at 11-12 and selling at 17-18.

Value Investment Group said...

Hi Lucky,

Rohit provided me the link to his post few days back. Rohit trades in ETFs based on the PE range, which is a good and low risk approach.

What I have mentioned in my article probably takes a step further. I would think about selling or reducing the investments including long term ones when PE is above 25 (which is pretty high compared to historic data). As you can see from the graph, the market have fallen sharply above 25 and almost always falls down to buying levels of < 15. This is rare, and as Rohit mentioned happens very low % of times. But, i think when it happens, I think there is a potential to profit from it.

Even the stocks which we normally keep for 10+ years can be brought at a much lower level again when market falls. I believe that was evident in last crash. Does the crash happen as soon as it crosses 25? may be not. And as mentioned in the article, this indicator is most useful when market is trading outside of normal range which is 15-25.

I think we are getting close to 21 now. Lets see how things go and hopefully we can test the same :-)


Roshni Bhatia said...

An understanding of P/E ratio is very important for normal investors before taking any investment decisions. Thanks for putting up this article which explains the significance of P/E ratio very clearly.