P/E Ratio stands for Price-to-Earnings ratio, one of investors’ most commonly used stock valuation metrics. The P/E ratio shows how much money an investor is willing to pay to get a piece of a company’s total earnings.

The graphs below display the comparison between the P/E ratio and the returns of Nifty50 over different periods; that is, five, three, and one year, respectively. The period of the analysis is from February 2006 till May 2022.

We can find that for most of the period, the P/E ratio ranges between 20 and 30, and Nifty 50 generated returns between 0 and 20%. The average PE ratio from February 2006 to 30 April 2022 stands at 22.46. Currently, the P/E ratio stands at 20 and the forward P/E ratio at 18. Therefore, the market is now fairly valued, meaning it is neither cheaper nor expensive. During 2006-2017, the P/E ratio stood at 15 to 25, taking the market into fair value territory with average returns despite the 2008 global financial crisis, which wiped away the wealth of investors accumulated over the years.

The Indian investment scenario has changed drastically in recent years turning India into one of the fastest-growing economies in the world. With the spike in internet penetration, the growing youth population with a higher standard of living, the reduction in corporate tax, and ease of doing business are attracting Foreign Institutional Investors (FIIs) into the Indian markets. All these took the P/E ratio of Nifty 50 above 25 in 2018 and 2019.

Since then, with the Corona pandemic outbreak, the subsequent digitization wave took the P/E ratio above 30. In 2021, it touched the 42 mark. This higher P/E valuation results from the CoVID pandemic and higher liquidity owing to the government’s efforts to avoid markets slipping into a recession. The pandemic-induced sluggish economy generated increased savings, and the equity market flourished as it attracted retail investors like never before. More than one crore new Demat accounts have been opened in those days.

Today, since companies are switching from working from home to hybrid or working from office models, hikes in compensation, salary cuts, reduction in interest rates, and layoffs reduce their profit margin. Moreover, on the macroeconomic front, supply chain disruptions due to the Russo-Ukrainian conflict and the Zero CoVID policy adversely affect economic and business performance, bringing the P/E ratio below 20.

Nevertheless, the Indian corporate earnings and market fundamentals are solid. The government invests heavily in infrastructure, deploys schemes like Production Linked Incentives (PLI), and supports micro, small and medium enterprises (MSME). In addition, the China Plus One policy and credit growth at the global level aid the growth prospect of the Indian economy and markets. All these initiatives and developments brought down one year forward P/E ratio to 18 and turned the Indian market more lucrative.

Conclusion

We should note that the P/E ratio and market returns are negatively correlated. Similarly, market returns and investment horizons are inversely proportional to each other. So, a higher P/E ratio and longer investment horizon will reduce the rate of returns on investment.

The table above shows examples of market returns and P/E ratio discrepancies. You can see that even if the P/E ratio is higher than 27 in an investment horizon of five years, we are holding a loss-making investment.

Bhavna Gupta

Alpha Research