Friday, August 28, 2009
Nifty P/E and P/B ratios
2 of the most important and basic analytic ratios are Price/Earnings and Price/Book Ratio. Lets us explore how they have behaved over the past 9 years.
Price to Earning ratio in layman's words is how many times the share trades to its profit made.
Infosys if it trades at Rs 2000 and Profit (Earning per share or EPS) is Rs 100, its P/E ratio is 20.
Price to Book value ratio states the number of times the company is trading to its book value. Book value is nothing but the assets of the company. If the company's assets are sold off tomorrow and money distributed to shareholders how much each shareholder will get per share. IT companies typically have high P/B ratios.
If we look at the past 10 years in graph above, we have add 2 bubbles in 2000 and 2008.In such extraordinary times, the P/E can go to even 28. We do not have bubbles every other year.
So in other times?
Market has corrected sharply when P/E is between 21 and 23.If you see the May 03 to May 04 period market has corrected sharply almost to hit the bottom again in P/E terms. Remember it would not be exact bottom because the earnings would have increased by then ( In 1 Year).
This has happened almost 4-5 times in last 10 years that market has reacted from P/E 21-23.
Also, historically it makes a bottom around P/E 11.
During the dot com bubble it made a top of 5 and 2008 of around 6.5. This time it made a higher top because there are companies in the Nifty like RPl and Reliance Petro who have low book value along with the IT pack.
What is interesting is the lows it made.It has bounced 3 times when price is just 2 times the book value.
What do the above 2 graphs tell us?
Correction could be round the corner. If we take P/E of 23 as top, then 5159 could be near the top on Nifty. Whenever it corrects from this level it can goto P/E 11 to 15 range.
This could be in Nifty terms 2600-3400 range. It makes sense to take profits off the table if you go by the P/E historical data.
One caveat, companies in the Nifty change, but we take nifty as a broad barometer of the Indian Market.Hence, everything evens itself out.
Lets see if history repeats itself this time.