What the PE Ra­tio Tells About Mar­ket Di­rec­tion

ByIn­vite

The Economic Times - - Companies - RITESH JAIN

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)

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