Why Indian market’s PE Ratio scaling New Highs?

Indian markets’ valuations have been scaling new highs. And that is with the indices still being some distance away from their all-time highs.

I was getting several queries regarding this and hence, decided to write a note on it. You can skip reading if you know why this is happening. It’s actually pretty simple, to be honest.

After an astonishing March 2020, Indian markets have staged a sharp recovery in the last few months. And I mean pretty sharp. Whether it’s justified or not is another matter. But of course not as sharp as the fall, but nevertheless sharper than what is generally expected based on historical data. But maybe, this is the year 2020 and hence, anything and everything is possible! 😉

But even the valuations have moved up sharply. From the highs of PE-29s in early January, we witnessed multi-year lows of PE-17s in second half of March.

But from then on, it has been an upward journey.

Have a look at the blue worn in the graph below. It has breached PE-31. Something that hasn’t happened in the past, ever.

But the rise in valuation isn’t just because of the markets (index) moving up.

Remember that P/E Ratio is made up of the ratio of Market Price (Nifty50 Index level), which is the numerator and Earnings per share (EPS of Nifty50) which is the denominator.

So normally, the ratio will increase if the index (numerator) increases. But if the index doesn’t increase and instead if the EPS (denominator) falls, then also the P/E ratio will increase. This is how the simple ratio mathematics works.

And in the present case of rising P/E, both the things have happened. Index has risen from its lows, i.e. numerator has been increasing. And EPS has also fallen in the last few months, i.e. denominator is falling.

Index rising is common. But why is EPS falling?

There has been a steady decline in underlying EPS of Nifty50 companies due to the lockdown of the last few months has resulted in lower revenues (and hence, lower earnings). And since EPS considers trailing 12 months earnings data, the lockdown/pandemic impacted months of April/May/June are now part of the trailing 12 months data being considered. And hence the fall in EPS.

As of now, the Nifty’s trailing 12-month (TTM) standalone EPS is down from highs of 450s (in Januarys) to 360s as of now (mid-August). See the falling red area in the graph below:

So a combination of a sharp rise in the index since March lows and a steady decline in the EPS of Nifty 50 companies in last few months, has resulted in a sharp spike in P/E Ratio, pushing it into historically unchartered territories.

To be fair, once the lockdown was announced (and was eventually extended), it was quite obvious that companies will face business disruptions. And that would result in revenue loss as well as earnings contraction.

The so-called experts have had their views / guesstimates of the extent of shrinkage. But assuming the pandemic subsides soon (fingers crossed!), it is also safe to say the earning will eventually see a recovery down the road. Whether it will be a sharp recovery or a gradual one is something that cannot be said as we are still not sure about how and when the pandemic will actually subside. That is, there are too many variables and no point predicting anything even now (and as usual).

But solely from the current valuation perspective and with one eye on the historical correlation of valuation and future returns, we are at unprecedented historical highs on the valuation front. And history tells us that markets do not remain attractive at these levels. In general, as the index valuations increase, the upside gets limited. Higher the valuation, riskier it gets. At least at broad levels.

But also remember that this spike in valuation is due to an outlier once-in-a-generation (or century) event.

The deviation from the means (of valuation) happens regularly. But sooner or later, there is mean reversion. Either due to fall in index (numerator falling) or earnings growth (denominator increasing).

By the way, never make the mistake of looking at PE in isolation. There are several components within the PE analysis itself and more importantly, there are several other factors (other than P/E ratio) that must be assessed before making any investment decisions. Be it at stock or at an index level (don’t confuse between individual Stock P/E ratio vs. Index P/E Ratio too).

Also Read: 2 Important things about Nifty P/E Ratio.

So the (current) high valuations shouldn’t be definitely written off and result in an exit from equity completely. You need to think deeper. In any case, perfect timing is a myth. You can never be sure about being 100% in equity or 100% in debt. So all we should aim for is to ensure that portfolio allocation is optimal at a given point of time.

In any case, for most investors, its best to focus first on their goals and then decide allocation and figure out a suitable rebalancing strategy. Some bit of tactical portfolio tilting is advisable. But do not just follow the trend and instead, objectively assess your circumstances before doing anything. Your risk requirements are different from others. So don’t copy what everyone else (or your close ones) are doing. If you are not very sure, then take professional help to plan your finances properly. Get yourself a proper financial plan made to bring your finances on track.