Recently share market has witnessed a V-shaped recovery as well as the prices of shares have gone up too, seeing this; the common investors may feel happy. But it is important to track the earnings behind this rise in prices. The Father of Value Investing Mr. Benjamin Graham quotes, “In the short-run, the share market is a voting machine but in the long-run, the stock market is a weighing machine.” Simply put, it means in the short-term, the fluctuations in the market are sentiments driven. While in the long-run, the prices of the shares track the companies fundamentals. In this regard, Mr. Peter Lynch quotes that, ‘Behind every share, there is a company. And this share tracks the performance of the company in the long-run.’
The common investors just get happy by seeing the increasing prices of the shares. So if the Sensex and Nifty are increasing then it is equally important to analyze if the underlying earning is also increasing or not. Just like Mr. Warren Buffets quotes, “Price is what you pay. Value is what you get.” For this you need to assess the PE ratio as mentioned in our previous video. Currently, the Nifty PE has crossed the mark of 27. So that means if we invest Rs. 27, we’ll earn Re. 1. So here the earning yield is 100/27 is equals to 3.7. So this earning yield is even less when compared to the Bank FD which somewhere around 6%. So currently, the share market valuation is expensive. Thus, in this expensive market, it is advisable to invest less.
Now in the upcoming period the earnings of the company may decrease since there had been a lockdown. And even later, the companies won’t be able to post a quick recovery because it will take some time for the work force to come back into action. The share prices have increased but the earnings haven’t increased as such. Hence, it is important to track the PE ratio. If the earning is increasing at a greater pace when compared to price then there’s an opportunity there. But instead if the price is increasing at a greater speed than the earnings, then a bubble of price is created in such a situation. So, even if we invest here, we don’t earn good returns or the market undergoes a correction here.
Let us understand this concept with a simple example. If we analyze the data from the year 1996 to 2003, then we find that Sensex which is the Index that represents the Indian share market consisting of the top 30 companies has earned an increase of how much percentage of earning yield per year? Now earnings here refer to profit. So in these seven years their earning yield increased only by a meagre 1.21% per year which is very less. During the last seven years, the companies in the Sensex didn’t grow at a greater pace. Due to this, the Sensex also performed in a limited range in those seven years. And when Sensex tried to perform over and above the earnings or crossed the level of earnings, every time it recorded a fall.
Now if we analyze the data from the year 2010 to 2020, we find that the companies in the Nifty recorded an increase of only 5% – 6% in their profits. So in these 10 years, Nifty itself was expected to give returns of 5% to 6% annually. And whenever Nifty crossed the mark of these returns, it resulted to a fall in the market. That means whenever the price will increase more in comparison to earnings recorded, tit will lead to a formation of price bubble in the market and the market will become expensive.
So how do we identify this price bubble or expensive market, early on? This is possible using the Price Earning Ratio. Price Earning Ratio tells us if the market is expensive or not based upon the earnings. Hence, we have said this in almost all of our previous videos that it is very important to check the market valuation. Nifty which represents the Indian share market, its Price Earning Ratio has always moved within the range of 10 and 30. So whenever it goes beyond the mark of 20, the market becomes expensive and when it crosses the mark of 25, the market will become even more expensive. Hence, one should invest less in an expensive market and you should invest in those companies whose earnings are expected to grow at a faster pace along with having a sustainable competitive advantage in the market. So we should make this investment in the market in a step-by-step manner by following the market valuation. That means investing less when the market valuation is expensive and investing more when the market is not expensive. In this way we can earn good returns from the market.
From the past two or two and a half years, the market was at a higher valuation being at the mark of 25 to 28 during that time we had asked all to invest less in the market. Recently, when the market fell down due to corona pandemic and the PE went down to the mark of 18, we asked all to invest more if they wished to. So we to followed, what we asked others to do. So when that had happened, we had said that the market valuation has become moderate, so you should invest only 50% here. How this will work? So from here if the market goes in uptrend, we will earn good returns on our investments and if the market goes in downtrend, then we will again have an opportunity to increase our investments there as we had invested only 50% earlier. Later when the market will go bullish then we’ll earn a good profit there. In this way if we form a pyramid of our investments here, we’ll definitely become a successful investor.
If you invest in companies by following the market valuation the you can earn good returns there. But in which companies should you invest? We have already discussed about this in our earlier blog about long-term investment. Do give it a look.
If you wish to become a successful investor, then the first step is to check the Price Earning Ratio i.e. the valuation of the market. We can analyze whether the market is expensive or not with the help of the PE ratio but the company where you are investing, the more important thing than analyzing the company’s individual PE ratio is analyzing the company’s business model. Also, the company which you have chosen for long-term investment should have a constantly growing earnings pattern and to keep this momentum going, if the company has a sustainable competitive advantage to it then you can earn good profits here by way of long-term investment.
So if you want to regularly analyze what the Nifty PE is or what is the current Debt to GDP ratio or what is the Market cap to GDP ratio then download our ‘Aryaamoney’ app and get the regular updates for the same. Also, if you wish to open your Demat account with one of the leading brokers of India then we have provided the link for the same below. Thus, to be successful in the market, it is important to check the market valuation before investing as Mr. Buffet has rightly quoted, “Price is what you pay and value is what you get.”
Until our next blog…
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