Price to Earnings ratio (PE ratio) is a key valuation measure of how expensive the stock market is relative to the earnings of the underlying businesses. The chart above tracks the PE ratio of the index over the last 20 years.
At the end of last week’s trade, NIFTY50’s PE ratio was a phenomenal 32.79. To put that into perspective, levels like these were never seen before in the last 20 years from 1999-2019. The median PE of NIFTY50 during this time was just 20.
Here is a frequency distribution chart showing the number of months over the last 20 years NIFTY’s PE ratio spent on different levels. The average level is anywhere between 18-23. The current level is far down the right of the bell curve indicating the market is clearly extremely overvalued.
The reason this ratio is so important is that investment returns from the stock market are negatively correlated with the level of PE. Higher the PE, lower the returns.
To help you see it, this chart below shows the 5-year return on investment made over each month of the last 20 years. To help you interpret it, Rs.100 invested in January 2000 when the PE ratio was just above 25 would have returned just under 5% per year over the next 5 years.
What you should be able to see is that when the yellow line goes up, the green line goes down and vice-versa – negative correlation.
Finally, here is a chart showing the average 5-year annual returns earned on investments made at different PE levels of the market. To help you interpret this chart, an investment made when NIFTY50 PE level was between 11-12 returned close to 40% CAGR over the next 5-year period (on average).
This chart tells us that to make at least fixed deposit equivalent returns from the stock market, we have to wait till the PE ratio gets to 23-24. And for that to happen now, one of two things will need to happen
- Earnings of NIFTY constituents will have to go up significantly without any corresponding price increase of stocks OR
- There will need to be a massive correction in stock prices.