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How changes in Index Constituents impact Index PE Ratios and PE Based Investing?

I was working on a more comprehensive P/E Ratio analysis of Nifty and Sensex when I thought about bringing this important point to everyone’s notice.

In December 2015, Sensex underwent few small changes. Two companies in the 30-share index were replaced. Adani Ports & SEZ and Asian Paints were added to the index and Hindalco and Vedanta were removed (source). I am sure that weak performance of the two outgoing companies combined with a bleak outlook for the metals sector in general, must have necessitated this change.

Now this is not unusual. The index management committee regularly reconstitutes indices to (and I guess) take index to newer heights by only allowing companies with better incremental earning potentials. 🙂

So what will happen when two low profit (or loss-making) companies are removed from the index?

By replacing these companies with profits-making ones, the total earnings of Sensex will increase. This would mean a lower PE ratio, which is calculated by dividing the total market cap of the constituent companies in the index by their total net profits.

And as we can see from table below, the immediate impact of this change was that PE came down on the day of change, inspite of index going up.

Sensex PE Ratio 2016

So this particular fall is PE is not because of fall in share prices. It is purely because the index constituents have changed and consequently, earnings have increased. For those who thought that markets have come down suddenly in valuations, this is something to make note of.

This change will also have an impact on Sensex valuations based on future earnings estimates. That is another matter the estimates are at best, estimates. 🙂

I wanted to highlight this because I regularly make references to link between returns and market PEs and how one can use this indicator to broadly assess market valuations.

Extend this concept of change in index constituents and you will realize that when comparison of index’s PE in 2016 is made with say of year 2001, then essentially, two very different indices might be getting compared.

To put it simply, the index of 2016 would be quite different from that of 2001. Sensex of yesteryears might be giving more weightage to metal and cement companies. In comparison, index of today might be more biased towards sectors like FMCG and IT. So when we compare historical PE ratios with current ones, then we need to acknowledge that we are not exactly comparing apples to apples. Due to law of averages, its also not like apple-to-orange comparison but its still not the same apples we are talking about. 🙂

Another thing that worries me is management framework of the index. I am sure that the index management committee would be doing their jobs honestly and carrying out required due diligences, when including and excluding companies in indices. But I am not sure whether there are any SEBI norms governing them or index changes.The indices traded on stock exchanges are owned (not sure) and managed by separate legal entities that do not come under the direct supervision of SEBI. I think there is a scope of increasing regulatory oversight here.

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Written by Dev Ashish

Founder - Stable Investor Investing | Personal Finance | Financial Planning | Common Sense

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