Don’t let a high PE ratio deter you from investing

Doubts are being raised on the sustainability of the current market rise, on the grounds that the high price-to-earnings (PE) ratio enjoyed by stocks is not warranted by the fundamentals.

This view says that for the PE ratios to come down to lower levels, the prices have to fall.
An alternate scenario could be made out where the prices stay constant, or even rise, and at the same time, the earnings of companies go up, so that the PE ratios actually decrease over a period of two to three quarters.

Indeed this is exactly the situation which occurred in January 2003. At that point, the Sensex was at 3311 with a PE ratio of 16.35. At the end of June 2003, the Sensex had gone up to 3607 and the PE ratio had come down to 14.61.

During this period the Sensex, rose by 8.9% and the PE ratio fell by 10.64%!

This was not an isolated instance. In nine out of 10 periods given in the table, the Sensex increased at a rate higher than the rate of increase in PE ratio.

Therefore, merely looking at the PE ratio in isolation would present a misleading picture of the markets. We need to factor in the growth in the denominator, i.e. the earnings of the Sensex constituents, in order to get a realistic picture of where the markets are headed.
Enter the PEG ratio, which rationalises the PE ratio to take into account future earnings growth. The PEG ratio, which divides the PE ratio by the expected growth in the earnings, flattens out the distortions caused by periods where the markets have run up in expectation of future growth, but this has not yet been reflected in the earnings of companies.

While growth in earnings is not a given, the following factors point to a return of the high rates of a couple years ago: 

After a disastrous 2008, we are coming off a low base of earnings. A small pickup in economic activity could herald a significant jump in earnings growth. This is further borne out by the latest IIP figures which show a rise of 10.4 % in the industrial production for August.

The furious pace of infrastructure development, coupled with the fiscal stimulus, is likely to push up revenues for basic industries and a corresponding increase in profits. A trickle down effect would benefit smaller ancillary units.

Corporate tax collections for the half-year ended September 2009 indicate a strong growth in the incomes of India Inc for the quarter.

Stabilisation in global economies augurs well for the confidence to return among export oriented industries.

Further, the low rate of investment in stock markets among Indian households and a lack of alternative investments which beat inflation are likely to encourage more local investments in stock markets via mutual funds and market-linked insurance plans. This could provide a base of stable money which would reduce volatility in our markets.
The shifting preference of foreign investors towards riskier assets means that the flood of liquidity headed towards our markets could turn into a tsunami. The government’s stated agenda of disinvestment in stakes of public sector undertakings would act as an excellent counterbalance to this liquidity, preventing a sharp rise in the markets and at the same time, ensuring that the sentiment among investors improves, thereby creating a virtuous loop of investments and fresh supply.

The above does not suggest that the only way that the markets could head is upwards, but certainly the positives in the economy far outweigh the negatives. Therefore, the most likely scenario is that markets move in a narrow range, thereby allowing the earnings to catch up with the prices and then re-rate upwards. If the markets do fall, they are far more likely to do so because of global events triggering a collapse rather than under the weight of a high PE ratio.

(The writer is proprietor of Capital Management Services)