Many people track Nifty PE Ratio regularly to gauge the market sentiments. And more importantly, also compare it with historical trends to assess whether the markets are overvalued or undervalued.
This is also one of the several factors that I keep a track off as an investment advisor for the last several years.
And if you see any sufficiently decent analysis linking P/E Ratio & Future Nifty returns, then, you will be surprised to see the correlation.
But analyzing Nifty P/E ratio is not just about looking at the current value and comparing it with past values. No. It’s much more than that. There are many nuances and facts that you should keep in mind when making such correlations and comparisons.
So I wanted to highlight a few important facts about Nifty P/E Ratio that investors should keep in mind.
Standalone Vs Consolidated P/E
Usually, the Nifty P/E ratio related data that is widely tracked is sourced from NSE (link). And NSE uses standalone earnings of constituent companies of the index for arriving at the ‘E’ of the P/E ratio, instead of using consolidated figures.
But in my view, a better approach would be to use consolidated earnings of the companies instead. 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, several of these companies have large subsidiaries. As a result, the subsidiaries (at times outside India, i.e. overseas subsidiaries) make significant contributions at revenue as well as earnings level. So, the consolidated earnings are quite different from standalone earnings for many of the companies in the index.
So when the published P/E ratio of Nifty50 continues to be based on the standalone earnings, it ignores the contributions of subsidiaries/group companies which wouldn’t have been the case in case of using consolidated earnings.
As a hypothetical example, let’s say that we are comparing P/E of index in the years 2003 vs 2020. Now in 2003, the index is (assume) at 2000 and the earnings (standalone) is 100 while earnings (consolidated) is 102. So P/E (Standalone) would be 2000/100=20.00 while P/E (Consolidated) would be 2000/102=19.61. Not much of a difference between 20.00 and 19.61.
Fast forward to 2020, the index is at 10,000 and the earnings (standalone) is 400 while earnings (consolidated) is 500. So the new P/E (Standalone) would be 10,000/400=25 while P/E (Consolidated) would be 2000/500=20. The difference is not ignorable now.
So what this means is that the PE20 in earlier years doesn’t exactly mean the same thing as the PE20 in current times. And you need to keep this in mind when doing any comparisons across time periods.
Note – Many statistically inclined (& rather excited) people spend too much time debating consolidated vs standalone earnings thing and how index PE correlation with future returns works or doesn’t. Such discussions, beyond a point, are useless. The idea is about mean reversion here. And that is a reality. If people don’t get that, then they will never understand how correlation works (and what things are to be kept in mind while using such correlations. To each his own I guess).
Nifty Constituent Companies: Past Vs Present
Even a casual look at the index composition will tell you how different the index is today than it was in the year 2000 or 2005. The index composition is now managed very actively and regularly (link) and hence, the weightage of sectors/industries in the index changes over time.
Now all sectors aren’t the same. And these different sectors/industries have different PE ratio ranges that are considered normal for that industry or sector. Due to their very nature, some industries will have higher PE than normal while others will have lower PEs than normal.
So if the index is made up of a large number of companies which have low PE in general, then the PE of the index will also be low accordingly. While if the share of high-PE companies increases in the index, then so will be the impact on index PE as well, i.e. it too will tend to remain high comparatively. Isn’t it?
As a hypothetical example, assume index is made up of 5 companies equally. In year 1, these companies are from low-PE industries and hence, have PE of 11, 12, 13, 14 & 15 during normal (fair value) years. The index PE is 13. Now in a bull market, the PE of these companies rises to 17, 18, 19, 20 & 21. The index PE also rises to 19.
Now after about 10+ years, the index constituents have changed. The companies primarily belong to high-PE industries and hence, have PE of 21, 22, 23, 24 & 25 during normal (fair value) years. The index PE is 23. Now in a bear market, the PE of these companies falls to 17, 18, 19, 20 & 21. The index PE comes down to 19.
As you can see, the index PE is 19 in both cases. But if you compare it with their inherent normals, the first_PE of 19 shows overvaluation, while second_PE of 19 shows undervaluation.
And that is what needs to be kept in mind when comparing index PEs across years. That due to the nature of the companies in the index, its possible that the definition of fair, under and overvaluation will change to some extent.
So the optical Nifty PE levels can remain elevated for long periods of time. But that doesn’t mean that they are necessarily overvalued. It might also mean that the constituent companies are such that the new normal has shifted.
All said and done…
Are the 2 factors discussed above the drawbacks of PE-based investing? You can call it that. But point is that one should never consider just one factor for investing. Always base any investment buy/sell decisions on multiple factors.
Mathematically (and ideally), if you are able to invest at lower PEs and are also able to timely book profits at higher PEs, you will definitely get very good returns. But you cannot time the markets perfectly using any models. So you can’t be 100% in equity on one day and 0% the other. It won’t work and it’s not feasible. So it’s best to use factors like PE in the overall multi-factor models that take into consideration multiple factors and assign proper weights before making investment decisions.
Also, Index PE mean reversion is a reality. It happens and it will continue to happen. It is important to understand though that how exactly it is happening. Is it by way of price correction or earnings correction?
Do read – Why Index PE Ratio is making new highs? (August 2020)
As an investor, you should simply try to maintain a proper portfolio with prudent asset allocation and that is periodically rebalanced. That’s it. You can have a static rebalancing approach or can even go for a strategic + tactical asset allocation approach that includes tactical rebalancing to try and further enhance returns.
Markets will always oscillate between high and low PEs. But this doesn’t exactly mean that every time it’s high, its overvalued and will correct sharply. Similar, it also doesn’t mean that every time its low, it’s undervalued and will rise sharply. You need to be situationally-aware and see things in the overall context.
So that’s it. Just wanted to share these 2 important aspects of Index PE as these days, many people look at it without understanding the full meaning of these figures.