4/7/2016

TheEconomicTimes
Title:ByInviteWhatthePERatioTellsAboutMarketDirection
Author:RITESHJAIN
Location:
ArticleDate:04/07/2016
Thepriceearnings(PE)ratioisoneofthemostwidelyusedvalueindicatorsandquiteprominentlyused
byinvestorswhileinvesting.StockswithlowPEratioareperceivedashavingcheapercurrentprice,
henceexpectedtogeneratehigherreturninthesubsequentperiod.
PEratioiscomputedbydividingthemarketpricewiththecompany'searningpershare.Thestudyofthe
historicaltrendinthePEratiooftheindexgivesusefulinformationtoinvestorsontheattractivenessof
themarket.
Generally,therearetwovariationsofthePEratioonebeingtheTrailingPEratioandtheotherbeing
ForwardPEratio.TheTrailingPEratiousestheearningsofthelast12months,whiletheForwardPE
usestheexpectedearningsforthenext12months.TheForwardPErequiresestimatingtheforward
earningsandhence,ispronetoestimationerrors.Moreover,thesameisnoteasilyavailable,whilethe
TrailingPEratioiseasilyavailableonarealtimebasis.
SCENARIOSOFPEEXPANSIONORCONTRACTION
WhentheIndexrisesatafasterpacethanearnings,PEexpands.Inversely,whentheIndexfallsata
fasterratethantheearningscontraction,itleadstoalowerPE.
STUDYOFSENSEXTRAILINGPRICEEARNINGRATIO
WehavedonestatisticalanalysisofmovementinSensexPEratioforthelast16yearsandhavetriedto
estimatethelikelyreturnsbasedonregressionanalysis.TheaveragetrailingPEratiooftheSensexhas
beenintheregionof~18.6.Whileittouchedahighof29duringthedotcombubblein2000,ithitalow
of12in2008duringthesubprimecrisis.
BasedonthelevelofPEandsubsequentindexreturns,weobservethattheIndexenterstheovervalued
zoneatPEofabove21andundervaluedzonebelow16(whichisroughlyonestandarddeviationaway
fromthehistoricalaverage).
ThecurrenttrailingPEat18.8ismarginallyhigherthanhistoricalaverage,thoughitdidcomebelow17
duringthemonthofFebruary2016,beforemovingup.ItispertinenttonotethatthetrailingPEhasbeen
intheregionof17orbelowforabout30%ofthetimeoverthelast17years.
REGRESSIONANALYSISOFSENSEXPE&INDEXRETURNS
Aspointedoutearlier,thereisastrongrelationshipbetweenthePEratioandstockmarketreturns.We
ranaregressionofSensexreturnsbasedonhistoricalPERatio.WecomparedtheSensexreturns
predictedbytheregressionanalysisover1,2,3and5Years.TheregressionofSensexPEandthe
subsequent2yearreturngivesthebestfit.TheRSquare,ameasureofhowwellobservedoutcomesare
replicatedbythemodelisat0.65,(therangeforRSquarehighest1andlowest0),indicatingafair
amountofpredictivepowerofthemodel.
CONCLUSION
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ThereisastrongcorrelationbetweentheTrailingPEratioandtheSensexreturnsandstudyofthesame
providessomeusefulinsightsintothestockmarketreturns.Goingbythehistoricaldata,andour
statisticalanalysis,theSensexdelivershigherreturnwheneverthetrailingPEratiomovesbelow17,and
tendstodelivernegativereturnwheneverthesamecrosses21.Investorscanusethisimportantindicator
whiletakingdecisionsofentryorexitfromthemarket.
(RiteshJainisCIO,TataAssetManagement)
DISCLAIMER:
Theviewsexpressedinthisarticlearepersonalinnatureandinisnowaytryingtopredictthemarketsor
totimethem.Theviewsexpressedareforinformationpurposeonlyanddonotconstruetobeany
investment,legalortaxationadvice.Anyactiontakenbyyouonthebasisoftheinformationcontained
hereinisyourresponsibilityaloneandTataAssetManagementwillnotbeliableinanymannerforthe
consequencesofsuchactiontakenbyyou.PleaseconsultyourFinancialInvestmentAdviserbefore
investing.TheviewsexpressedinthisarticlemaynotreflectintheschemeportfoliosofTataMutual
Fund.
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