Sensex and PEG ratio: Are valuations justified?

PEG ratio is the P/E ratio dividend by the EPS growth of a company. The general thumb rule is that an investor should avoid buying into a company when the PEG ratio is in excess of one. What this means is that the valuations should be justified by the earnings growth. As stated by Peter Lynch, "The P/E Ratio of any company that's fairly priced will equal is growth rate".

We shall apply this logic for the Sensex. We will take a look at two things - the P/E ratio of the Sensex and the index's year on year change in earnings per share. We have compared these parameters for two five year periods - one ended 2007 and the other starting 2008.

If we see the Sensex P/E ratio over a long term, it has averaged at about 18.5 times. Going by the logic of the PEG, the P/E ratio would be justified if the earnings growth rate was in excess of this figure. This seems to have been the situation prior to 2007.



As you can see, the Sensex EPS was volatile (may not be a 100% accurate due to the method we have calculated the EPS growth; at the same time, the extreme volatilities may be due to non-adjustment of extraordinary items, change in the index constituents, amongst others) during this period, but it would be fair to assume that the growth rates were in excess of 18.5%. Taking an average of the EPS growth during the period, it stood at nearly 27%. The average P/E during this period stood at about 18.2 times.

Now let us move on to the period post 2007 i.e. from 2008 till present. The scenario changes quite a bit. And this at a time when the general view (including ours) was that the overall markets are attractive considering that the benchmark index is trading below its long term average P/E ratio. But when we apply the above mentioned logic, it does seem to paint a slightly different picture.




As you can see, unlike the pre-2007 era, the EPS growth rates declined or reduced substantially. While the earnings growth rates have improved off late, they still stand below the average growth rates during the period 2003 to 2007.

With these data points, it does seem like the argument about the Sensex being attractive especially when compared to the historical valuations does not hold true.

So, are Sensex stocks expensive?

Ideally, the PEG ratio should not be applied to an index which has a basket of stocks from different sectors - including those from cyclical industries/businesses. The ratio is useful to compare two firms in the same industry with similar fundamentals and also in some sense for companies with steady growth levels. As such, based on this analysis one cannot conclude that all Sensex stocks are expensive at current valuations.

Should you or Should't you ape FIIs or DIIs

If there is one thing certain about the stock markets, it is the uncertainty. The stock ticker always seems to tread a shaky and capricious path. With no clarity in sight, small investors often resort to taking the cue from the big investors. Are the foreign institutional investors (FIIs) buying or selling? Which stocks and sectors are the FIIs betting on? Where are the domestic mutual funds putting their money? What are the fund managers saying about the market and the economy? 

Investors are often under the impression that the so-called big guys really know what's going on in the economy and the stock markets. With so many experts crunching loads of data, this presumption may not be too farfetched. But the thing is that the economy is way too complex and intricate for any expert to fully fathom it. As such, following FIIs and domestic institutional investors (DIIs) blindly could be misleading. 

An article in Moneylife points out at some interesting data. Through most of 2012, FIIs were pumping money into the Indian stock markets. For 10 of the 12 months, they were net buyers. On the contrary, DIIs were net sellers for 9 of the 12 months. 

But this is not where their differences end. Both FIIs and DIIs have differing views on different sectors, sometimes even stark opposite. For instance, FIIs have been bullish on banking and financial services sector. However, DIIs are bearish on this sector. If you compare the top 10 FII underweight list and the top 10 overweight list of domestic mutual funds, you will see that FIIs are buying some of the same stocks that the DIIs are selling, and vice versa. 

If two so-called experts share opposite views, whom should you listen to? Our answer is no one. Why so? There are several factors and institutional compulsions that determine FII and DII investing behaviour. For example, redemption pressure and scarcity of new fund inflows could force mutual funds to sell off their stocks. On the other hand, FIIs have their own set of problems. Any adverse financial situation in their home country could force them to flee away from the Indian markets. Plus, they have to deal with the currency risk as well. 

In addition, both FIIs and DIIs are often prone to following the 'institutional imperative'. For the uninitiated, Warren Buffett  describes the 'institutional imperative' as that urge for managers to mimic what their peers are doing even if it may seem irrational. The performance of fund managers is closely monitored over the short term. This may make them short-sighted and unwilling to take contrarian bets. 

It is certainly easy to accept that small investors are not constrained by the above mentioned limitations and have significant advantages over these big investors. As such, it would be best you do not pay much heed to what the FIIs and DIIs are doing. Do your own research and stick to the principles of value investing. This has worked brilliantly for some of the world's most successful investors. There is hardly any doubt why it will not work for you. 

Theoretically the stock markets are considered to be the barometer of an economy. Considered a lead indicator, they are supposed to reflect the direction the economy is going to take in the coming times. Therefore when our very own BSE-Sensex breached the 20,000 mark in January 2013, everyone thought the economy is taking a turn for the better. But the recently released economic data seems to point to the contrary. Dismal numbers for the IIP (Index for Industrial Production) suggest that the economy is still not out of the woods. So why have the stock markets been heading upwards? Simple, it is because of the flood of cheap money that has invaded our markets. With developed economies printing money like there is no tomorrow, a large part of it has found its way into India. This has led prices of asset classes, particularly stocks, to run up in recent times. As a result, stock markets do not seem to be reflecting the true state of the economy. However, it must be remembered that this can only continue for a short period of time. In the long term, the relationship between earnings and stock prices has to hold. So either the economy would take a turn for the better. Or the stock markets would come crashing down. 

"So it's a terrible mistake to look at what's going on in the economy today and then decide whether to buy or sell stocks based on it. You should decide whether to buy or sell stocks based on how much you're getting for your money, long-term value you're getting for your money at any given time. And next week doesn't make any difference because next week, next week is going to be a week further away. And the important thing is to have the right long-term outlook, evaluate the businesses you are buying. And then a terrible market or a terrible economy is your friend." - Warren Buffett