The full form of PE ratio stands for price to earnings ratio and it is one of the most simple but very helpful buy/sell indicators for all investors who believe in buying good companies at throwaway prices. It is used to analyse valuation. It helps in judging how cheap or expensive a particular stock or index is. In simple words, it implies that how much amount an investor is willing to pay to earn one rupee profit.
Nifty PE ratio
Nifty P/E ratio or Price to Earnings ratio works same as P/E ratio of individual stocks. It measures the average P/E ratio of the Nifty 50 companies. Say if the PE ratio of Nifty is 26, it implies that the investors are willing to pay 26 rupees for one rupee profit together earned by all the companies included in Nifty.
When Nifty PE trades at or above 22, Nifty is considered to trade in an overbought zone while when it trades below 14, it is considered to be undervalued.
Professor Sanjay Bakshi said-
“Recent research done by my firm shows just how dangerous it is to remain invested in an expensive market. Since NSE started, every time when Nifty’s Price/Earnings ratio exceeded 22, the average return from Indian equities over the subsequent three years became negative”
Ideally, long-term investors who are into value investing usually buy stocks when P/E reaches 14 or below and avoid buying when P/E goes above 22. The table below gives a brief idea about the P/E based valuation.
Analysis based on present Nifty PE ratio
Nifty PE ratio as on 17th May 2017 was trading at 25.23 and Nifty closed at 9525.75 making a lifetime high of 9532.60. Presently, the market is trading at a highly overbought region where price is moving at a much faster pace than its earnings. Have a look on fundamental analysis for detailed understanding
Previous two times when Nifty PE crossed above 20, the earnings growth were not that strong, however, it’s not the case this time as earning per share is rising simultaneously. This reflects that this time market is moving on sound reason rather than just on the hope of optimism.
Psychology based on PE ratio
If we look into history, we can clearly see that whenever Nifty goes above 22 PE, market undergoes a correction. It would be very interesting to see what happens this time.
Usually it is seen that when Nifty is in the overbought zone, money flow enters the market. General people has a tendency to avoid making investments when Nifty PE enters the oversold region. This is just opposite than it should rather be and it clearly highlights herding mentality.
Also read: The fallacy of law of demand in stock market
Also read: Equity Performance – What Lies Ahead In 2017-18
Bottomline
This time it’s not just the optimism but solid structural changes have been made by our government which suggests that it’s just the beginning and with further improvement in earnings per share, the Nifty PE would gradually come down and market may further rally from the current levels.
This article is written by Mr Ankit Jaiswal – Knowledge Associate – Elearnmarkets.com. A commerce graduate from St. Xavier’s college, Kolkata . He strongly believes in the following saying by Warren Buffett-“Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it”.
