We frequently hear that the Sensex is fairly valued or trading near or above its historical price-to-earnings multiple of 18 times. The price-to-earnings ratio, or P/E, is a valuation measure that compares the stock price to company profits, providing investors with a sense of the stock’s value.
Let’s try to understand what P/E is and how the Sensex valuation can be interpreted from it.
Mathematically, the P/E multiple can be expressed as ratio of market price of a stock to its earnings per share, or EPS. For example, let’s say the stock price of Reliance Industries Ltd is Rs 900/share and its EPS is Rs 90.
Since P/E = Price/EPS, the P/E of Reliance is 10. This implies that investors are willing to pay 10 times Reliance’s EPS for that year. Do note, this is not a static figure and the latter can change every time the company declares its quarterly results. As for the stock price, it fluctuates daily. Naturally, the P/E changes accordingly.
In general, investors are greedy for highly profitable or high growth opportunities and stingy with opportunities not as attractive. Similar behaviour is displayed in P/E multiples where high growth companies trade at higher P/E multiples and lower growth companies trade at lower multiples. For example, software companies like TCS and Infosys, and consumer goods companies like Hindustan Unilever and ITC, trade at P/E multiples greater than 20. On the other hand, companies in the energy sector are trading at less than 15 P/E multiples, thanks to the current subdued oil price environment. A lower P/E can also indicate a company’s lower future earnings potential.
The above can also be seen in Sensex P/E multiples.
The Sensex composes of 30 stocks which are traded on the Bombay Stock Exchange, or BSE. The index is constructed on the basis of the free floating market capitalisation of these 30 stocks traded relative to 1978-79 taken as base value of 100.
Free float based market capitalisation implies all shares which are freely available for trading. Therefore, promoter equity and equity held by other entities are kept out of the free float calculation.
The Sensex P/E is the ratio of price of the index to its EPS. Price per share is derived by dividing the combined free floating market cap of all the 30 index constituents by their total outstanding shares. Similarly, EPS is the ratio of the aggregate earnings of all the 30 stocks comprising the index to their total outstanding shares. In a way, the Sensex P/E is nothing but a reflection of the individual PEs of its index constituents.
Historically, the Sensex has traded at an average P/E of 16-18 and in a range of 9-24 times EPS. During upcycle or periods of strong growth, the Sensex has traded at the higher end of the range as the earnings of the index constituents start growing strongly. Conversely, in a downcycle or during periods of subdued growth, aggregate earnings of index constituents fall or the rate of growth slows and investors are not as willing to pay a premium to earnings. Consequently, P/E multiples fall to the lower range. If the sectors which have a higher weightage in the index do well, the Sensex P/E would largely increase.
In a given time period, different sectors trade on different P/E multiples. Currently, stocks in sectors such as oil and gas, and metals, which are facing subdued operating conditions, are trading at P/E multiples much below that of the Sensex P/E. For example, RIL and ONGC are each trading at around 9-10 times EPS.
On the other hand, sectors which are doing well, such as fast moving consumer goods, healthcare and information technology, are trading at rich multiples of 20-40 times EPS, much higher than the Sensex P/E.
Many of these richly valued stocks require a much lower capital expenditure and generate strong free cash flows with high operating margins. Keeping this in mind, investors are ready to pay a hefty premium for these stocks. Hence, when making relative valuation comparisons of the Sensex P/E to another country’s P/E, it is important to know if the index in question has a similar sectoral representation, else the conclusion would be erroneous.
Similarly, comparing the Sensex P/E in 2015 to that of the Sensex in 2005 or 1995 should also be kept in context. After all, the index composition during all these time periods would differ.
So while it’s one of the oldest and most frequently used metrics, ensure that you use it within context.
