Led by 850 points gain in the Sensex, Indian stock market rose to its 3-week high by the end of this week’s trading.
These gains were led by improved earnings guidance from the technology major Infosys, and slower-than-expected growth in factory output that seemed to have fuelled speculation the central bank may halt its interest rate increases.
Data Source: Yahoo Finance
Despite this week’s rise, the Sensex is still down around 17% this year (since January).
The question on top of mind of most investors I meet these days is – “Are Indian stock markets cheap now?”
Well, to answer this question on a broad basis, let us look at the price to earnings or P/E ratio of the Sensex. The P/E is a good measure to check the temperature of the market, and suggests whether stocks are priced expensive or cheap as compared to companies’ earnings.
The Sensex P/E thus represents the average P/E of all the 30 companies that form part of the index.
Here is how the Sensex P/E chart looks like.
Data Source: BSE
We have used data for the last 15 years to see a long-term range for the Sensex P/E. This period includes 3 major crisis periods (1997, 2000, and 2008), and is thus a good indicator of the valuations of large Indian companies across several business cycles.
As you can see from the chart above, markets have been the cheapest at around 10 times P/E. The most expensive level was reached in April 2000, or at the height of the dotcom bubble, when the P/E touched almost 35 times.
However, as the chart shows, stocks become expensive when the P/E crosses 20 times. Of course, they’ve gotten more expensive than 20 times in the past, but those were the periods of irrationality, which is not what comforts sensible, long-term investors.
The Sensex P/E currently stands at 18.6 times earnings (last 4 quarters’ earnings), which make stocks (on an average) reasonably valued and not very expensive.
Now, this is where the fuzzy concept of ‘forward earnings’ comes into picture.
You might hear from stock market experts that although stocks look reasonably valued at 18.6 times based on last 4 quarters’ earnings, they are cheap when compared to 1-year forward earnings.
Since forward earnings of companies are always expected to rise (don’t ask me why), this means that the numerator of the P/E ratio will rise.
So when you take today’s price (P), and divide it by next year’s earnings (E), you will get a lower P/E. Interesting, isn’t it?
Now, why I call ‘forward earnings’ as a fuzzy concept is because these (forward earnings) are usually inflated by improper adjustments and blind optimism.
See, it’s good to be optimistic in life. But continued optimism is dangerous when it comes to investing in stock markets.
Realism, and not optimism, is a good friend of an investor.
Coming back to the question – “Are Indian stock markets cheap now?” – looking at the long range P/E of the overall Sensex, they look reasonably valued and not really cheap.
But then, while trying to pick up individual stocks, I as an investor would be more worried about individual P/E ratios – of companies I’m looking to buy.
For instance, while the Sensex P/E is at 18.6 times, some stocks are trading at 30-35 times, while there are others that are trading at 10 times.
So, it is important for you to ascertain whether a stock is expensive or cheap on an individual basis. Look at its business, its past track record, its standing in the industry, its strengths and weaknesses, its management quality, and its valuations (like P/E).
Then take the call whether the stock is worthy of investment or not.
The ‘stock market’ P/E can give you some indication, but just treat it as an indication and not your reason for investing.