Index price to earnings ratio: Myth and reality

Asia's Tech News Daily

#Classroom, #Expert Columns, #Nifty, #Sensex

Numbers do not lie, but they can belie their own inferences. A case in point is the P/E (price-to-earnings) ratio, especially the P/E ratio of the index. The ratio of market price per share and earnings per share, which helps us know whether the stock price reflects the value in terms of earnings potential. Having said that, one should overlook the fact that PE Ratios are best compared within entities of the same industry as different sectors have different benchmarks for arriving at the desirable PE ratio range.

When it comes to PE ratio at the index level, the specific contexts of multiple factors become even more crucial. The ratio of Nifty PE for instance is index market capitalisation/ gross earnings. The numerator is the aggregate of outstanding equity shares multiplied by the adjusted traded price of respective constituents in line with the chosen methodology.

The denominator stands for the sum total of adjusted earnings of each constituent (based on trailing, forward, or average earnings). The adjustments account for factors like free-float and capping factors. It is crucial to understand the subjectivity of both numerator and the denominator to put the index PE in perspective.

Numerator

The Nifty composition is based on weightages. The chosen 50 stocks score high on factors like listing history, liquidity, free-float market capitalisation, and trading frequency. Although the index value is computed daily in real-time, its composition is not fixed, and it changes over time. Obviously, stocks with higher weightage are in the driver’s seat for steering the index points. And the drivers change over time. The index PE may go up and down in line with the index weightage which may not reflect the true picture of value.

Denominator

The earnings considered for the Nifty PE are standalone, not consolidated. This means the earnings of all other businesses of the constituent group are not considered. In today’s age of rampant M&As (mergers and acquisitions, the standalone inferences may not reflect the real PE. Another point to note is the trend of earnings. Abnormal occurrences like the pandemic may distort PE calculations, so also reported earnings based on different accounting practices of differing capital and revenue distinctions.

The PE is essentially a story of varying numerators and denominators. Consider different scenarios: one, a booming market where earnings have been stagnant, two, a sluggish market with a significant drop in earnings, three, a market crash with static earnings, and four momentum markets with receding corporate earnings. All these cases will lead to misleading conclusions about ‘growth’ and ‘value’ investments if we do not consider other factors governing the rise and fall of markets.

One way to counter this subjectivity is to consider the broader market PE and Price-to-Book Value as it is more authentic from the accounting perspective and less prone to cyclical variations besides finding easy application across sectors. One can also compare earnings with bond rates to arrive at better conclusions about the short term. Using the price/earnings to growth ratio (PEG ratio) is another option, which is arrived at by dividing stock’s price-to-earnings (P/E) ratio by the growth rate of earnings. This ratio can help assess value based on current and future earnings potential.

Index PE, much like the indices themselves, has a rich reference value that helps us understand where the market is placed and where it is likely headed, but it is certainly not prescriptive in the context of trading and investing decisions. It does not convey the holistic picture of the market and its movements. Markets are elusive by nature. Hence, one should not be unduly fixated on the indices and their PEs.

Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.

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