Stock Market Valuations: A Comparative Study of PE Ratios

We frequently encounter the question, “Is the Indian stock market overvalued?’ One of the ways to answer this question is to compare India’s stock market with markets in other nations. However, it is very difficult to compare markets, but we can compare the Price-Earnings ratio of the stock market index to see the relative picture. 

The PE multiple (Price to Earnings ratio) has been one of the most popular approaches to equity valuation. PE ratio of a company is calculated by dividing the current market price of the share with its earnings per share (EPS). Thus, PE ratio indicates a number which is a unit of company earnings that an investor is willing to pay. Hence, it could be used to compare if the stock is cheap or expensive as compared to other stocks in the same industry. Similarly, we can calculate PE of the Index and we can use the index PE to determine the relative value. 

For the study, we obtained Price-Earnings ratio of leading stock market indices of four developing countries (Brazil, Russia, India and China - BRIC countries) and three developed nations (United States of America, United Kingdom and Australia). For making meaningful comparison, we obtained the daily PE and have calculated the average of daily PE for the calendaryear. In case of India, we obtained PE ratio for both the leading indices: NSE-Nifty and BSE-Sensex. 

In Table 1, we observe that during 2008-2016, the PE for India’s stock market index generally varied between 15 and 19. In 2012-2013, Nifty and Sensex had the lowest average PE at 14.8 and 15, and since then the average has increased. The average PE for Nifty, for the year 2017 (till November 2, 2017) was 22, and on November 3, 2017, it was 23.7. 

A high PE indicates number of years it would take for an investor to recover his capital if the company gives all its earnings to the investor. In a simple language, if the EPS is at Rs10, and I pay a price of Rs100 to buy the share of a company, the PE ratio will be 10, which indicates that it would take 10 years for me to recover the Rs100 invested, if the company continues to earn Rs10 every year and gives it to me. 

In the current context, where NSE-Nifty’s PE is 23.7, it would take an investor over 23 years to recover the investment. This recovery time can be shortened if the company’s earnings grow significantly. The potential of growth in earnings is a crucial indicator, and so we should keep an eye on it. 

Russian market has the lowest PE andlooks very attractive for wealth creation, but as we can see, even historically, this market trades at a single digit PE. In 2007-2008, when Lehman Brothers collapsed, the average PE of USA-S&P500 was 16.8, and Nifty was trading at PE of 20.9, which means India was relatively expensive. Even as on date (November 3, 2017), we see that USA-S&P 500 is trading at PE of 22.7, and Nifty is at 23.7, which suggests that relatively the two markets are valued nearly the same. However, one needs to keep in mind that earning’s growth potential is much higher in the case of Indian markets as compared to the US market. 

On October 11, 2017, USA-S&P 500 made a new all-time high with PE of 22.87. For India, the all-time high PE for Nifty was 26.83 and for BSE it was 26.33 recorded on January 10, 2008. Since Indian markets are currently trading close to a PE of 24, there is still some headroom for the markets to grow. 

Foreign institutional investors (FIIs) always invest in markets which are growing, are fairly priced, and offer potential for wealth creation. It is important that India presents better growth opportunities and ease of doing business to attract foreign funds. On the ‘Ease of Doing Business’ front, India has shown a remarkable improvement in the ranking by the World Bank (2018 ranking), and has jumped 30 positions up to grab a place amongst the top 100 countries in the world. This should help India in getting more investments. 

Currently, since the stock markets in India are driven largely by internal funds, if the market sentiments remain positive and the government works towards smooth implementation of GST, with a robust investment plan in infrastructure and banking, we should be able to scale higher. Retail investors should continue to look for stocks which have margin of safety and offer wealth creation in the long run.