“Markets must have equilibrium .. and the entanglement of emotions and logic must be minimised”: This is my eternally unfulfilled wish. The stock markets are doing what they do best. Fluctuate. Regardless of 200-point rises, the markets seem to be gradually inching downwards. Everything is tried to make the markets look attractive and lure the investors in. One measure that is commonly used is the Price to Earnings Ratio (P/E).
The most commonly repeated thing I find is that the markets are trading at or around 15 times 2011-12 earnings. I believe that this is on the assumption of around 15 per cent earnings growth in this financial year. So, logically, if I extrapolate the expectations, the markets ought to be trading at around 19 times 2010-11 earnings. Alas. We are all taken in by something called a ‘free float’ index as well as the funny ‘weighted’ average market capitalisation etc. If the index had, let us assume, only three stocks, with one stock having half the market capitalisation, it would impact the other two dramatically. All its own ratios would have a strong impact on the market numbers.
If the market statistics as above in terms of Price to Earnings were right, we should have most of the stocks in the index trading at around 18 or 19 times 2010-11 earnings. Right?
What I noticed is an eye opener. At this level (Nifty around 4,900 and BSE Sensex around 17,000), the average price to earnings ratio of the stocks in either of the indices is 22 times!
Even if I were to factor in a 15 per cent growth in this number, it gives me a market that is trading at more than 18 times 2011-12 earnings! When we break down and look at the components, we see that we could perhaps buy around one third of the stocks at the levels considered attractive by the experts. Alas, if we dig in to the stocks, we will find that some stocks trade at single digit P/E multiples and are likely to continue to do so.
Hence, all these calculations are not a great thing for stock picking. It may be good if you are going to buy the Index as scrip and want to look at pure market returns. The other co-relation the P/E would have is with the interest rate environment. The higher the interest rate available on savings, the lower should be the P/E on the stock markets.
If a country has a 20 per cent interest regime, why should I pay 10 times earnings for a stock, unless the stock is going to have a perpetual earnings growth in excess of 30 per cent? We have a situation where equities may not deliver anything for a few years. I would wait for markets to spend time at these levels or fall down another 20 per cent or so.
The writer is an independent investment analyst.