Index PE @ 28 Buy Or Sell?

PE ratio is the barometer of valuation of a stock or index. However, it is erroneous to look at the PE level of an index or stock and compare it with the historical averages while investing. Rather, for investing, investors should identify those stocks that are trading at relatively lower PEs and the growth is intact in such stocks. Shohini Nath and Yogesh Supekar discuss how much further can Nifty go in-spite of its current high valuations, while Vinayak Gangule highlights the underlying trends for the Nifty constituents.

- Shohini Nath And Yogesh Supekar

Often, in high growth markets like India (emerging markets), the PE (price-to-earnings ratio) is high as investors are willing to pay that much more for the estimated growth. The most important aspect in a growth environment is how much should one pay for the estimated growth. Is there any additional risk of investing in high growth environment? What are the risks of investing in equity when in general the PE ratio is high for the majority of the stocks, including the index?

The risk of investing in high growth environment is that there is always a possibility that the estimated growth may never materialize and the investors may find themselves trapped in stocks or indices at higher prices. It is very important while investing in growth stocks that one should realistically estimate the growth rate. Most investors get punished for overestimating the growth rate while opting to invest in growth stocks in the growth environment.

While the risks for investing in high PE stocks are known, majority of the investors carry a perception that investing in low PE stocks is less risky and that excess returns are possible only by investing in low PE stocks. Let us understand what is PE multiple actually and what factors determine a PE.

PE multiple demystified :

PE ratio, also known as the price multiple or earnings multiple, is often used by investors and analysts alike to compare valuations of stocks. PE ratio tells us how much is the market willing to pay for a single share for every rupee it earns a profit. If the PE ratio is 20 for a listed stock, it simply means that the market is willing to pay Rs 20 per share for that stock for each rupee of profit it makes. It is important to understand that loss-making companies will not have a PE ratio.

The same logic applies to the index PE ratio.