Nifty PE Ratio and Market Returns

Nifty is currently close to the 11000 level. Although we know Nifty is close to its all-time high, does this number on an absolute basis tell us whether it is the right time to invest in the market? Can investors know if Nifty will keep moving higher from these levels or will it collapse to new lows? Over the last two decades, the index has scaled multiple peaks and also suffered some heavy blows. Volatility is a part of the game in stock markets. The Nifty price/earnings (PE) ratio is one of the key indicators to determine overvaluation or undervaluation in the market. The PE ratio is a function of sentiment and earnings. If investors feel positive about the future prospects, they will invest in the stock market, thereby taking the stock prices higher.

 Also, if the companies deliver positive earnings growth, it means the per share value of the companies rises, which in turn leads to more investments in those companies. The index PE is calculated using the sum of market capitalisation of all index companies divided by sum of consolidated earnings of all index companies. There are two variations of this ratio: trailing P/E and forward P/E. The trailing PE ratio uses the earnings of the last 12 months, whereas the forward P/E uses earnings estimates over the next 12 months. The forward P/E is more prone to errors, therefore, we have used the trailing P/E to analyze historical returns. The way to interpret this number is that the index PE ratio is the number of rupees investors in the market are willing to pay for every one rupee of collective profit made by companies in Nifty. This number is most useful when compared with historical numbers. PE ratio can also be a function of interest rates, as lower interest rates means companies get to borrow funds at a lower cost, which the market discounts in the stock prices in anticipation of future earnings. Thus, it is important to understand that PE ratio is a leading indicator and should be looked at in the context of earnings and interest rates. 



Over the past 20 years, Nifty has delivered positive returns in 15 years and negative returns in 5 years, with a CAGR of 13.4 per cent. However , investors’ returns would have varied greatly depending upon the point of time they chose to invest in the market during the last two decades. For example, the Nifty PE ratio in January 2018 made a high of 28 times on the back overoptimistic sentiments and growing SIP inflows into mutual funds. The year 2018 saw the Nifty deliver only 3.2 per cent returns and the broader markets suffering some serious damage.

It is said that investors must remember god in the good times and equities in bad times. Historically, the times of maximum pessimism have proven to be the greatest investment opportunities. This, of course, is easier said than done. For example, if an investor had invested Rs 100,000 in the Nifty at the end of 2002, when the PE was 14.8x, the investment amount would have been Rs 993,374 at the end of 2018. 



January 2008 saw the peak of the so-called infrastructure and real estate bull market in India. The Nifty was scaling new heights every day, IPO market was booming and earnings growth was strong. However the Nifty PE had crept up above 27 times. As we know now, the Nifty collapsed by over 50 per cent causing widespread panic in the financial markets. The PE ratio also collapsed and made a low of 10x in October 2008. There was extreme pessimism and panic selling in the global financial markets, but the investors who had the courage and the cash to deploy money at this time made handsome gains as the index delivered return of more than 75 per cent in 2009. 



The below table can serve as a simple, yet handy template for investors. 

Looking only at the average returns can be misleading as market movements are not linear. Averages are made up of some outliers on the upside and downside and also some stagnant years. This is illustrated in the below table: 




The PE ratio and index returns have shown a strong correlation historically. Investors benefitted when they invested when the PE ratio was below 12 and suffered losses or had to endure long periods without returns when they invested when the index level was higher than 24. However, the index has spent time below the PE of 12 only 1.5 per cent of the time since 1999. The above table highlights that investors who had bought into the market at a similar valuation, but at different points of time, could make very different returns. While the above table is certainly useful, basing investment decisions on only the PE ratio would be oversimplifying the investment process and may not be an ideal way of investing. Also, trying to time the market to catch peaks and tops is something even some of the greatest investors struggle to achieve. India is a growing economy with tremendous potential to grow at a minimum of 7 per cent for the next 10 years. We can be reasonably certain that this growth will be captured in the profitability of companies over a long period of time. For common investors, it is best to stay invested in the markets for the long term to enjoy the benefits equity has to offer and to outperform other asset classes.

Although buying when PE is low and selling when PE is high may seem to be an obvious way, most investors are known to behave just the opposite. They tend to buy when the markets have been in an upswing for a while with an inflated PE. They justify their investment decisions based on the past performance. This is because investor sentiments can move in extremes and the past is not always indicative of the future. As the saying goes, history does not repeat in stock markets, it rhymes! 



"It is said that it is not intelligence in the market that makes money but temperament. The ability to stomach volatility is one of the most important traits of every successful investor. The courage to deploy cash at the time of severe pessimism in quality stocks at attractive valuations is a trait demonstrated by some of the biggest investors for wealth creation in equities."


The above table clearly indicates that being a contrarian when there is a crisis of confidence yields handsome rewards. The current Nifty PE stands at approximately 26 times earnings as per NSE, as against an average of 18 times. The looming general elections and the high valuation means the market is unlikely to scale new heights in the immediate future, unless there is an earnings surprise, which would lead to the PE getting deflated and appear more attractive. It is also important to remember that the severe drawdown witnessed in 2008 was a rare event and a similar crash from the high valuations would be unlikely. However, volatility is inevitable and informed investors will use it to their advantage. It is said that it is not intelligence in the market that makes money but temperament. The ability to stomach volatility is one of the most important traits of every successful investor. The courage to deploy cash at the time of severe pessimism in quality stocks at attractive valuations is a trait demonstrated by some of the biggest investors for wealth creation in equities. 



The direction of the index in 2019 is difficult to predict, but now we know when we need to adopt a more cautious approach and when we should show the necessary courage to take action when the opportunity presents itself. In conclusion, it is clear that index PE and Nifty have a strong correlation, which should help make better investment decisions.

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