Note – I have updated this analysis in 2017 here.
I had been working to make this analysis more useful. Like all previous updates, this one too has index (Nifty 50) analysis of 3, 5, and 7 years. But this time, I have also added an analysis of 10-year returns. Since most readers of Stable Investor are interested in long term investing, it made sense to add an analysis for a longer tenure.
In addition to that, I have also incorporated few more tracking points to give a more comprehensive P/E based picture. The details will become evident as you go through this analysis.
So what exactly is that this analysis tells?
To put it simply, it tells that it makes sense to invest (if possible, more) when general indices are trading at lower PEs. This statement is based on last 17 years’ worth of analysis.
But mind you, there is ofcourse no guarantee that the trends might continue in future.
So this analysis tells about the possible returns one can get when the money is invested (in index) at various PE ratios.
Let’s go ahead with the updated findings…
The table above clearly shows that if one is investing in markets where PE<12, the average returns over the next 3, 5, 7 and 10 year periods are astonishing 39%, 29%, 23% and 19% respectively. Now this is something remarkable. The money is doubling every 2-4 years.
On the other hand are PE ratios above 24. These are levels that are considered to be highly overvalued, in market terms. And returns on money invested at these levels, for the next 3, 5, 7 and 10-years are (-)5%, 3.4%, 9.6% and 12%.
This shows that if you invest in high PE markets, your chances of low (and even negative) returns increase substantially.
And for your information, we are currently trading at close to PE 19.
So as you saw, investing at lower PEs gives bumper returns. But does it mean that it will always be so?
The answer is No.
Because the above numbers are ‘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. And to handle this point, I have also found the maximum and minimum returns during all the periods under analysis.
As you can see, there is a big difference 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 market. Yes, it sounds like timing the market. But this is a reality. For those who can, timing the market works beautifully.
But point is that most people can’t – And this is the reason why they shouldn’t try it either.
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 average 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. I strongly recommend you read this post on importance of Standard Deviation by Prof Pattabiraman here.
Now, lets touch upon a very important point. Buying low makes sense. 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.
Look at the time spent by the index at sub-PE12 levels.
It is just about 2% 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 – that might be spaced years apart.
Another useful thing to note here is that as your investment horizon increases, the expected returns more or less are good enough, even when one invests at high PEs.
So, even if an investor puts his money in the index at PE24, the expected average returns are more than 12%. That’s pretty good enough.
And what about the maximum and minimum achieved since 1999?
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. On the contrary, if someone was thinking to invest at high PEs (above 24) for less than 3 years, then I am almost certain that this person will lose money.
- Becoming a Value Investor using Nifty PE Ratio
- A Small Guide I refer to when investing in Stock Markets
Now you might be tempted to ask – what is it that I do with my own money (after knowing all this since I have been doing this analysis for past many years)?
The answer is that I have tried to keep my financial life simple.
I have few base SIPs running all the time. I don’t disturb them whether it’s a low PE market or a high PE one.
Since I am also interested in giving booster shots to my long-term returns, I invest additional amount when I feel comfortable with valuations on the lower side. I also keep a Market Crash Fund that I use every now and then. I have covered about it in detail here, hereand here. But I don’t recommend that approach to anyone. It’s for people with time and intent to track markets closely.
For most readers, knowing the market PE gives a broad idea about the valuations of overall markets. It helps ensure that you know when the markets are over-optimistic and hence, it reduces the chances of making mistakes when investing. It also helps in knowing when the overall mood of the market is down and probably, full of more than necessary pessimism. Let your base SIPs run irrespective of market levels. But see if you can benefit from some of the insights that analysis like above provides. 🙂
Reminder: I am talking about index-valuations here and not individual stocks.
A reader had asked me to create a PE chart to show monthly changes in Nifty valuations. Heat Map below shows monthly Nifty valuations – based on index’s monthly average PEs.
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.
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.
During the same period, profits have grown from 180 crores to 1600 crores at rate of 27% plus.
Earnings (per share) have moved up from 1.8 to 10.3 in 2012. In line with EPS, dividends have started increasing in recent past and now (in 2013) stand at Rs 2.6 per share. In last 5 years (barring 2009), company has continuously increased its dividend per share (1.2, 1.2, 1.5, 2.0, 2.3, 2.6).
|Earnings & Dividends Per Share (2003-2012)|
The dividend payout ratio has also stabilized in the band of 20-23%, which is decent considering the high growth rate of company’s business. A detailed comparison between EPS, DPS and their respective growth rates can be found in table below-
|Detailed EPS & DPS Data – Growth Rates & Assumptions|
IDFC is a financial institution and hence it makes more sense to analyze company’s Price to Book Value to gauge how over- or undervalued the company is.
Price/Book Value & P/E Ratio Analysis
Company has grown its book value from 16 to 81 in last ten years. That’s a CAGR of more than 20%.
|Book Value Per Share (2003-2012)|
We analyzed historical data to check the P/BV multiples at which IDFC has traded. Average P/BV after listing (in 2005) for IDFC stands at close to 2.3. Also it has oscillated in a P/BV range of 1.0 to 5.0. At present, the stock is available at a P/BV of 1.6. That itself points to a 30% undervaluation from historical averages perspective.
If you look at Price to Earnings multiple too, average PE commanded by IDFC is close to 16. The stock currently trades at a PE of less than 11 (TTM). And if you are enterprising enough to consider future earnings, then stock is available at a forward PE of 9.2 (FY 14) & 7.7 (FY 15)! And a PE of 8 is considered apt for a no-growth company. 🙂
|P/BV Comparison – Current, Historical Average & Estimated (2014, 2015)|
|P/E Ratio Comparison – Current, Historical Average & Estimated (2014. 2015)|
The company, though well managed and growing at a decently fast pace, seems to be undervalued. We have not analyzed management, business, etc as this post was more to do with valuations based on simple historical parameters. But being headed by Deepak Parekh and his team, it is assumed that management would be doing a decent job. In case you are interested in understanding more about the business, management and other factors, we suggest a simple Google search. It will throw a plethora of brokerage reports analyzing the same. You can also access company’s latest Annual Report here.
- Buy at PE12 & Sell at PE24
- Buy at PE13 & Sell at PE23
- Buy at PE14 & Sell at PE22
- Buy at PE15 & Sell at PE21
- Buy at PE16 & Sell at PE20
|Percentage of time spent by Indian markets at various PE levels – Last 13 years|