Don’t Confuse Good PE Ratio Of Index VS Good PE Ratio For Stocks

Most of you understand what a P/E ratio (Price-to-Earnings) is. In the investment world, P/E Ratio is one of the most widely used tools; and often, the use turns into abuse by many.

If you have some doubts about what PE ratio is, you can look up more about it on Google or Wikipedia. Otherwise, here’s a short refresher.

PE Ratio Stocks vs Index

Mathematically, PE ratio is calculated as the market price per share divided by the earnings per share (EPS). Typically, the calculation of PE ratio takes EPS of the trailing 12 months (some take forward earnings too).

In words of Morningstar, Price-to-earnings ratio (P/E) looks at the relationship between a company’s stock price and its earnings. So, what does it tell you? If it’s high or is going up, then it shows that the investor sentiment for the company’s stock is favourable, at least theoretically. A drop in the P/E Ratio or a generally low P/E ratio indicates the market has less confidence about the company’s ability to increase its earnings.

Another factor to remember is that different sectors/industries have different PE ratios ranges that are considered normal for that industry or sector. Therefore, the PE ratio of any company must always be compared within its industry/sector. Due to their very nature, some industries will have higher PE than normal while others will have lower PEs than normal. So, this should be remembered as the very basic when trying to compare the PE ratios of different companies.

PE ratio is a popular factor used to evaluate companies, but it’s also used at an index level. Though there’s a difference between the PE ratio of a company and PE ratio of the index — which is made up of several companies itself. You can read more about different Nifty indexes here.

You have to remember to be cautious about the term ‘Good’ when used with PE ratio. Why? First of all, what makes a PE ratio good depends on the industry/sector a company is part of. So, a PE 25 may be good (undervalued) for company A while it may be very bad (overvalued) for company B. Also, for valuation conscious investors, a lower PE is better than higher PE when comparing past historical P/E ratios of the same company. But that’s too broad a generalization as PE isn’t (and shouldn’t be) the only factor being considered.

To be fair, there isn’t any fixed rule for what a good PE ratio is. In general, most value investors would consider a lower PE as better assuming other factors are the same (which rarely are).

Note – A high PE doesn’t necessarily mean that a stock is overvalued or a low PE doesn’t necessarily mean that the stock is undervalued. Any analysis of PE ratio needs to be done as part of the overall analysis of multiple factors related to the company, sector, industry and the economy as a whole. Never use the P/E ratio in isolation. You might end up making wrong investment decisions.

As mentioned earlier and at the risk of sounding repetitive, sectoral or industry PE ratio should be cautiously handled. PE ratios could vary from sector to sector and from industry to industry. A P/E which is considered high in certain industries can be considered very low in many others.

But what about PE of Index?

Index PE is a different animal due to its inherent structure. It’s the weighted average PE ratio of the stocks the index constitutes. That is, Nifty PE ratio measures the average PE ratio of the 50 components of the Nifty index. In general, a low Index PE indicates an undervalued market and a high index PE indicates an overvalued market.

I’ve done detailed analysis in the past about how the index P/E ratio can be used as one of the factors to assess possible future returns. You can check this detailed study here: Nifty P/E Ratio & Returns: Detailed Analysis of 20-years.

Note 1 – The index-based PE formula has 2 components. Index level and EPS of the index. So, it’s possible that mathematically, the Index-PE Ratio may increase as the market keeps on increasing (numerator) without any increase in earnings (denominator). Similarly, the index PE might fall if the market is stagnant (numerator) while earnings fall (denominator).

Note 2 – There were a lot of PE related moves in the last few months, more specifically after March 2020 when the pandemic threatened the world market. So, when Indian markets corrected sharply in March, the index (numerator) fell while earnings (denominator) remained static. This means that PE just crashed as detailed in this post. But from April onwards, the index (numerator) has been rising while earnings (denominator) have been falling. This has led to the sudden expansion of PE ratio due to the double impact of rising numerator and falling denominator. I have written about the sudden rise in PE ratio of markets in detail which you can read.

For India, average market PE ranges vary depending on the time period under consideration. It’s possible that in earlier years when low-PE industry stocks were part of the index, the average would be lower than what it is nowadays as more high-PE industry stocks are part of the Indian indices. You can check historical PE ratios of Indian markets on the NSE website (and also see the correlation between Index PE and Future returns). By the way, different countries have different index PE dynamics depending on which companies were part of the index and on what stage of economic growth these countries are. So, at a given time, it’s possible that the PE of a developing economy’s index might be much higher than that of the index in a developed market. In lieu of that, it’s possible that for some other market, the average market PE ratio ranges from 20-25x while for some other, it might even range from 10-15x. You can check different list of sites to figure out PE for companies, industries, etc. for different markets.

It must be reminded that index PE is gradually becoming a popular tool for investors to gauge market sentiments. But only using one factor to arrive at any decision (at index or individual stock level) isn’t right. So be careful.

Note – Since we’re talking about average index PE and similar stuff, I must warn the readers that averages don’t tell everything. This is a fundamental mistake that many people make in investing and in life. Do read about how a 6-ft tall man drowned in a river of 5-ft average depth. So always be careful about using average to arrive at an investment decision.

You shouldn’t ideally rely exclusively on the P/E Ratio as E in the ratio represents earnings and we all know that accounting practices isn’t the same across companies. So, earnings reported by each company should be taken with a pinch of salt as companies’ promoters/managements want to paint a rosy picture in front of everyone even if things are of a different colour. Always consider other factors as well when using index PE to make investment decisions.

One important thing to note about index PE calculations is that as of now, NSE uses standalone earnings for arriving at the E of the P/E ratio. But a correct approach would be to use consolidated earnings of the companies instead as it gives the true picture of the constituent companies. This is because earlier, Indian companies weren’t as large as they are today. So the consolidated earnings of many of the larger companies were more or less the same as their standalone earnings. But now, many companies have large subsidiaries and have made large overseas acquisitions. As a result, the subsidiaries have significant contributions at revenue and profit level. So, the consolidated earnings are quite different from standalone earnings for many of the companies in the index.

Having said that, the ratio does give a decent measure of how expensive the overall markets are at any given point in time. It also allows for comparison across the historical period, assuming you understand a few things about how index composition changes influence such an analysis, etc.

Overall, there’s a reasonably strong correlation between the trailing PE ratio and the Nifty returns. One just needs to be careful about how to use these insights along with other factors to make investment decisions. This might sound like it’s a trying to approach the decision in a timing-the-markets type of a way. But that’s fine. In a way, that’s true even if most people won’t admit to it.

So that’s more or less about why and how you shouldn’t confuse between PE Ratio of Index and PE Ratio of individual stocks. Be reminded (and I am sorry for the repetition but this is very important) that irrespective of whether you’re analyzing a stock or an index, don’t look at its PE in isolation. Slice and dice the PE data at various levels and use several other factors (inputs) as well.

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