Price to Earnings ratio (P/E ratio) is a measure of price paid for a share relative to the profit earned by that share; i.e.
They say that it is best to invest when valuations are low.
Sensex is currently (December 2011) trading at a P/E of 16.5. So is this the right time to invest? Is this what experts call a low valuation? We at Stable Investor have decided to answer these questions.
Analysis of Sensex’s last 12 years data (from 1stJan 1999 onwards) reveals a few interesting points –
- Over any rolling period of 5 years in last 12 years, Sensex has not given negative returns! So if you are ready to stay invested (in this case, in an Indian Index Fund) for a period of 5 years, you won’t lose money.
- Returns earned during last 12 years, when segregated on basis of P/E ratios are –
|Returns (Over 3 & 5 years) & P/E Ratios|
This clearly indicates that at current P/E of 16.5, we have a chance of earning more than 15% per annum for next 3-5 years!
(Caution – This statement is made on basis of historical data. Past performance is no guarantee of future performance.)
So after analyzing this interesting relationship between P/E Ratio and Returns, what does a Stable Investor do?
- Stable Investor is now in a better position to respond to people’s view that it is better to invest in markets of lower multiples (P/E). Our analysis clearly shows that if investor invests in markets of lower multiples, probability of earning high returns is very high.
- P/E Ratios are still relevant for judging overall valuations of markets, if not individual stocks.
- It is advisable to invest when markets are trading in early teens (i.e. 13<P/E<16). It has also been seen that Indian markets tend to stay between P/E Multiples of 12 and 24 (Read Indian Markets PE 12 to 24 for details)
- P/E Ratio is a beautiful indicator of market’s overall valuation. But before making any buy or sell decisions, an investor should also look at a lot of other information/data.