P/E Ratio Analysis of Nifty Returns – 2017 Update

Edited: An updated and more detailed analysis is published in 2019 and is available here.

This is the detailed annual analysis – comparing Nifty P/E with Investment Returns.

It compares returns earned (during various periods ranging from 3 to 10 years) when investments have been made at various PE levels of the Nifty-50.

Before we get to the findings, lets try to understand the purpose of this analysis.

Purpose of comparing Nifty PE with Returns

First of all, this is not a sure-shot method to make money.

Just because we can find some clear trends from past data doesn’t mean that same will be replicated in future. Markets are dynamic and history is no guarantee of future. The sole purpose of this analysis is to realize that there is obvious relation between the market valuations and returns you will get. If you buy low (valuation wise), chances of earning good returns increase and vice versa.

This study tries to highlight the historical trends about possible returns one can get when the money is invested (in Nifty 50) at various PE levels. That’s it.

How to Analyse PE Vs. Returns?

What I have done here is that I have calculated returns earned on investments made at all Nifty PE levels. The time periods for return calculations are 3 year, 5 year, 7 year and 10 years.

Lets use a simple example to understand this.

Suppose you had invested money in Nifty on 24^th-February-2004, when its PE was 19.97 (actual data).

Now I have calculated returns starting from 24^th February 2004 for periods of 3, 5, 7 and 10 years. The CAGR returns have been 29.3%, 8.5%, 17.0% and 13.0% respectively.

This calculation has been done for each and every day since 1^st January 1999 (day since when Nifty PE data is available). I had several thousand data points for each of these periods. The days that do not have forward returns for 3-years have not been considered in analysis of 3-year returns (likewise for 5, 7 and 10 year studies)

To simplify the findings, I have grouped Nifty PE into 5 groupings.

Nifty-50 PE Ratio and Investment Returns

So this is what I have found:

Clearly, the data shows that when you invest at low PEs, your expected future returns are high.

So if one had the courage to invest in Nifty when PE was less than 12, the average returns over the next 3, 5, 7 and 10 year periods would have been an astonishing 39%, 29%, 22% and 19% respectively! But sadly, its very rare to find days where Nifty is trading at such extremely low valuations.

On the other hand, if investments were made when PE ratios were above 24 (which is the overvalued territory), the chances of earning high returns in near future are pretty low. Infact, money invested at such inflated valuation levels, for the next 3, 5, 7 and 10-years have earned on an average are (-) 5%, 3.4%, 9.6% and 12% respectively.

Also Read: Why I chose PE of 12 and 24 – Do Indian Markets Bounce off Nifty PE 12 and 24?

At the time of writing on this post, the Nifty PE is about 23-24 (more details can be found here).

But it is important to note that these figures are based on historical data (of last 18+ years). The trends no doubt are easily evident here. But they may or may not be repeated in future. There are no guarantees in markets.

Markets won’t behave as you expect them to behave just because you have found its rhythm. You will not get returns just because you want them.

This shows that if you invest in high PE markets, your chances of low (and even negative) returns increase substantially. Investing at lower PEs can give bumper returns! But it is not easy. It takes a lot of courage, cash and common sense to invest when everybody else is selling. It is very easy to sound smart and quote things like ‘be greedy when others are fearful’. Unfortunately, very few are able to be actually greedy when others aren’t.

But lets focus on another important fact here.

Risk with dealing with Average Returns

The table above depicts a very clean and obvious relationship between P/E and Returns.

But the above numbers are just ‘averages’. And that can be risky if you solely invest on basis of averages.

To explain this more clearly, lets take an example. Imagine that your height is 6 feet. Now you don’t know swimming. But you want to cross a river, whose average depth is 5 feet. Will you cross it?

You shouldn’t – because it’s the average depth that is 5 feet. At some places, the river might be 3 feet deep. At others (and unfortunately for you), it might be 10 feet.

That is how averages work. Isn’t it?

So this needs to be kept in mind…always.

Adding More Data points to PE-Analysis

A better picture can be painted if in addition to average returns, we also find out:

1. Maximum returns during all the periods under evaluation
2. Minimum returns
3. Standard deviation

Have a look at tables below now:

 

 

 

If you have observed carefully, there are big differences between the minimum and maximum returns for almost all periods

So the returns that you will get will depend a lot on when exactly you enter the markets. Two people entering the markets at (lets say) PE=17.2 would have got 5-year returns ranging from 2.6% to 33.0%. Shocking! Isn’t it?

My previous statement ‘returns that you will get will depend a lot on when exactly you enter the markets’, does sound like timing the markets. But this is a reality. For those who can do it, timing the market works beautifully.

Hence even though the average returns give a good picture for long-term investors (look at the table for 10 year), its still possible that you end up getting returns that are closer to the ones that are shown in minimum (10Y Returns) column and not the Averge Returns. 😉

This is another reason why I introduced the column for standard deviation in all tables above (see last column).

Analyzing standard deviation tells you – how much the actual return will vary from the average returns. So higher the deviation, higher will be the variation in actual returns.

Can You Catch the Markets at Right PE Multiples?

Ideally and armed with above insights, it makes sense to buy more when valuations are low. Isn’t it? Buy Low. That is the whole idea of investing.

But real life is not that simple.

It is very difficult to catch markets on extremes. Its like a pendulum – keeps oscillating between overvaluation and undervaluation.

So should you wait to only invest at low PEs? Though it might make theoretical sense to do it, fact is that it is very difficult to wait for low PE markets.

Just have a look at this 5-year table I shared earlier in this post too:

 

Look at the time spent by the index at sub-PE12 levels.

It is just about 1.7% of the time since 1999 (Ref: Column name ‘Time Spent in PE Band’ in tables above).

Markets at below PE12 are extremely rare.

For common investors, it’s almost impossible to wait for such days. Infact, such days might be spaced years apart.

So the best bet for common people is to keep investing as much as possible, via disciplined investing (like SIP in equity mutual funds). Its not perfect (like buy low sell high) but it is your best bet given all the constraints.

Long-Term Investors have Better Chance of Doing Well

Another insight that this study gives is that as your investment horizon increases, the expected returns more or less are reasonably good enough, even when one invests at high PEs.

Have a look at 10-year returns table below:

Now 10-year is long term.

So, even if an investor puts his money in the index at PE24, the historical average returns are more than 12%. That’s pretty good. And what about the maximum and minimum returns achieved when investing around PE>24? At 13.8% and 10.5% respectively, these are not bad either. This is what really shows that if you are investing for long term, equity is your best bet for wealth creation.

The longer you stay invested, higher are the chances of making money in stock markets…even if you have entered at higher levels.

Caution – I know that’s a dangerous statement to make but to keep things simple, please read it in the right spirit.

On the contrary, if someone was thinking to invest at high PEs (above 24) for less than 3 years, then there are very high chances that the person will lose money:

Asking Again – Whether This Approach works in all kinds of investing?

My answer is that no one strategy can work in all conditions.

Knowing the broader market PE gives a fair idea about the valuations of overall markets. It tells you when the market is overheating and that you should take cover. This in turn can help reduce the chances of making mistakes when investing. Similarly, this knowledge of PE-Return Relationship also helps in identifying when markets are unnecessarily pessimist. If you are brave at such times, you can make some serious money.

And please don’t think about investing in individual stocks just because Nifty PE is low. Individual stocks have their own story and need more in-depth analysis.

What about Nifty changes? Does it not impact this analysis?

That’s a valid point.

The index management committee that is responsible for index (Nifty 50) maintenance regularly bring in and move out companies from the indexes. The Nifty composition of 2007 was quite different from that of 2017. Similarly, the index composition of 1999 might too be different from that of 2007 and 2017.

Try to understand it like this. If the index is made up primarily of companies that are low PE-types, then index at overall level will tend to have low-PE. Whereas if the index is made up of high-PE companies, it will tend to have high PE. So actual definition of high and low PE will be different for both type of companies, and so in turn for index. A PE of 15 for low-PE company might be very high whereas for high-PE company might be very low.

This is an important factor that should be kept in mind.

I have written about how changes in index constituents can impact PE analysis earlier too.

What Should You Do as a Common Investor?

I am assuming that you are not Warren Buffett. 🙂 But jokes apart, fact is that most people do not have the skill or time to get into deep investing.

So what should such people do?

First thing is to simply stick with regular disciplined investing (easily achievable through MF SIPs).

With that taken care off, you should try to invest more when market valuations are low. This will help increase your overall returns in long term.

There is a strong (but not guaranteed) correlation between the trailing PE ratio and Nifty returns. And this small study proves the same and provides some useful insights. If we were to go by the historical data, the Nifty delivers higher return (in long term) whenever the PE ratio is low. On the other hand, it tends to deliver very low to negative returns, whenever the PE is very high and investment horizon is short.

You as an investor can use this insight as a backdrop to take your investments decisions.

Recommended Reading:

• Becoming a Value Investor using Nifty PE Ratio
• A Small Guide I refer to when investing in Stock Markets
• Do Indian markets move within ‘this’ PE band?

In case you are interested in reading previous years’ analysis, then you can access them here:

• 2012
• 2013
• 2014
• 2015
• 2016

I regularly update PE and other ratios of Nifty50 and Nifty 500 on State of the Indian Markets page.