Nifty PE Ratio Analysis

While examining our stocks for fundamentals the first thing we look for is its PE Ratio. Today we are going to examine the valuations of our index using PE Ratio analysis.

PE Ratio is calculated using the following formula:

Market Value per Share / Earnings per Share (EPS)

PE Ratio is simple yet powerful tool that tells us how expensive or cheap is the current underlying irrespective of the price. Let's see if our index pass that test.

For the purpose of calculation the PE Ratio of S&P CNX Nifty we need to divide the sum of market capitalization by the sum of earnings of all the companies that constitute the index. Don't worry we don't need to manually calculate the PE of Nifty every time NSE's Website has a tool which can be used to know the various ratios of market at any point of time.

Historical analysis of Nifty's PE reveal that markets are over sold under PE of 12-13 and overbought in the range of 20-25. So, everytime Nifty's PE fell to or under 12-13 range markets have rallied nicely and everytime it moved to 20-25 range it crashed despite of what TV experts and analysts have been telling the crowd.

Now, let's examine the returns given by nifty on investment at various PE levels for different time period:

image source: http://www.stableinvestor.com/

The table above clearly shows that if we invest in the index when its trading at PE less than 12, it can provide us bumper yearly returns of 39.5%, 29% and 24.9% over next 3,5 and 7 years respectively as per historical data. While if we invest at PE of 20-24 or above our chances of low or negative returns are relatively high.

As I write this post Nifty's PE stands at 22.12 which is not too far from its 15 year peak, hence not encouraging.


Views on Nifty at Present Levels:

Nifty PE has fallen from 9119 to 7940 levels, also the long term Elliott Wave analysis and breakdown from bullish channel suggest weak signs in the index. A correction has been due in Indian Indian markets now after the huge rally of hope in last one year. So, our view avoid fresh long term investments, especially in blue chips.

Also, one must not consider it as end of story because Indian markets have even witnessed its wildest bull run in 2007-08 from PE of 21 to 28, without any underlying change in earnings. If you are holding stocks with good fundamentals with long term perceptive you may hold and average at lower levels. Levels of 7700-7800 would be crucial for Indian markets as PE of 20 is a general buying zone in bull markets. Let's see if nifty hold those level or we are heading towards another bear market.
So, what above analysis tells us:

1) When Nifty's PE reaches levels of 12-13 start investing in the market for long term in different instalments despite of what others are telling you. If PE falls below 12 then it's a golden opportunity to get in.

2) If Nifty's PE moves above 20 then its time of caution. That doesn't means market will fall all at once but you must start booking partial gains in your long term holdings in instalments. You may consider shorting if market moves above PE of 25 or start falling from 20 PE levels after testing the 20-24 range.