What the PE Ratio Tells About Market Direction
The price earnings (P/E) ratio is one of the most widely used value indicators and quite prominently used by investors while investing. Stocks with low PE ratio are perceived as having cheaper current price, hence expected to generate higher return in the subsequent period.
PE ratio is computed by dividing the market price with the company’s earning per share. The study of the historical trend in the PE ratio of the index gives useful information to investors on the attractiveness of the market.
Generally, there are two variations of the PE ratio; one being the Trailing PE ratio and the other being Forward PE ratio. The Trailing PE ratio uses the earnings of the last 12 months, while the Forward PE uses the expected earnings for the next 12 months. The Forward PE requires estimating the forward earnings and hence, is prone to estimation errors. Moreover, the same is not easily available, while the Trailing PE ratio is easily available on a real time basis.
SCENARIOS OF PE EXPANSION OR CONTRACTION
When the Index rises at a faster pace than earnings, PE expands. Inversely, when the Index falls at a faster rate than the earnings contraction, it leads to a lower PE.
STUDY OF SENSEX TRAILING PRICE EARNING RATIO
We have done statistical analysis of movement in Sensex PE ratio for the last 16 years and have tried to estimate the likely returns based on regression analysis. The average trail- ing PE ratio of the Sensex has been in the region of ~18.6. While it touched a high of 29 during the dotcom bubble in 2000, it hit a low of 12 the region of 17 or below for about 30% of the time over the last 17 years. our statistical analysis, the Sensex delivers higher return whenever the trailing PE ratio moves below 17, and tends to deliver negative return whenever the same crosses 21. Investors can use this important indicator while taking decisions of entry or exit from the market.
(Ritesh Jain is CIO, Tata Asset Management)