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Thursday, July 18, 2013

Is the Sensex valuation signalling a ‘buy’?

Given below is a chart that appeared in the Economic Times a couple of days ago. For those who are not familiar with, or feel shy about, graphs and charts – a brief explanation may be necessary.

What is PE (Price to Earnings ratio)? It is a common valuation metric that is calculated by dividing a stock’s current market price by its TTM (trailing 12 months) EPS:

In other words, PE of a company = CMP (Current market price) / TTM EPS

EPS (or, earnings per share) is calculated by dividing the net profit by the total number of shares outstanding (i.e. shares authorised, issued and owned by investors, including company promoters).

Net profit is declared along with quarterly results of a company. Quarterly EPS can be calculated by dividing the quarterly net profit by the number of shares outstanding. To calculate the full year’s EPS, the quarterly EPS of three previous quarters is added to the EPS of the current quarter (i.e. TTM EPS).

sensex-pe

The Sensex is an index of 30 stocks. The ‘price behaviour’ of the index is supposed to represent the ‘price behaviour’ of the entire stock market. Does the Sensex have a PE, and can it be calculated. The answer is ‘Yes’. How?

By performing a simple arithmetic trick to make the calculation easier. For each of the Sensex constituent companies, CMP and TTM EPS are respectively multiplied by number of shares outstanding:

  • CMP x number of shares outstanding = Market Capitalisation;
  • TTM EPS x number of shares outstanding = TTM Net profit.

So,  PE of a company = Market Capitalisation / TTM Net Profit.

Now, calculate the market capitalisation of the 30 Sensex stocks; then add the 30 market capitalisation numbers (in Crores) to get the total Sensex market capitalisation. Next, add the TTM net profits of the 30 Sensex stocks (in Crores) to get the total Sensex TTM net profit. Dividing the total Sensex market capitalisation by the total Sensex TTM net profit gives us the Sensex PE. Voila!

Why is the PE ratio important? Because it is a commonly used valuation ratio. A PE of 15 means the market is ready to pay Rs 15 for each Re 1 in earnings of a company. A lower PE means the stock is a more attractive purchase. A higher PE means the stock is on the expensive side. Note that PE ratio should not be the only criteria to value a stock. Other metrics like Price to Book Value, Return on Capital Employed, cash flows from operations, etc. should also be looked at.

The chart above plots the Sensex PE from end 1998 to Jul 12 ‘13 (in red), with the average PE during the entire period of 18.34 (in blue). How to use the chart? Below the blue line is the ‘buy’ zone and above the blue line is the ‘sell’ zone. On Jul 12 ‘13, Sensex PE was at 17.65 – below the average level of 18.34. In fact, Sensex PE has been below the average level for the past several months. Now you know why investors were being implored to buy in various posts on this blog over the past few months.

Don’t worry too much about the gloomy economic scenario. The government is taking belated steps to allay the situation. The stock market cycle is usually a few steps ahead of the economic cycle. By the time the economy improves, it will be time to sell.

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