Dangers of blindly trusting the PE ratio

The price to earnings ratio is one of the most commonly used metrics to determine if a market is expensive or cheap. It is popular because it is easy to understand and calculate.

More sophisticated investors like the private equity industry use multiples like enterprise value (EV) to earnings before interest, taxes, depreciation and amortisation (EBITDA). This ratio is perhaps a better indicator of the state and profitability of the company as it looks at cash available to the investors across capital structure. The VC industry that funds startups have come up with their own strange metrics like the gross merchandise value (GMV) and customer life time value (LTV) etc. Since most of these startups have little to show in terms of revenue and profits, investors needed to come up with metrics that would let them evaluate the companies. It is easy to judge these in retrospect. However, this post is not about unlisted entities.

Coming back to PE, much like the oldest stock indices like the Dow and Nikkei, this metric too was supposed to be just an indicator. The Dow and Nikkei are what are called price weighed indices. The actual value of the company has little impact on the value of the index. It is basically equivalent to buying a stock each of these companies and sitting tight on it. The PE ratio too is something similar. It is just supposed to provide us with an indication of if the market is cheap or expensive.

However, in the recent times responsible institutions have been using this number to make investment decisions. Most notable here in India is IDFC Mutual Fund, which asks investors to buy or sell based on the PE value of the index. This is dangerous territory and I’m going to explain why.

The PE ratio of an index is the ratio of the price of the index to the earnings of the constituents weighed according to their weight in the index. For example if there are 2 shares of company A trading at say 100 and an EPS of 5, and 1 share of company B trading at say 200 and and EPS of 15, in the index, the price of the index is 100x2 + 200x1 = 400 and the earnings = 5 x 2 + 15 x 1 = 25. The PE of the index is 400/25 = 16.

Now let us assume that company B is replaced by company C in the index. Company C has the same market capitalisation as company B and trades at 200 too, but has an EPS of 10 instead of the 15 that company B had. The index price remains the same and the 1 share of B is replaced with 1 share of C.

But what happens to the EPS. The new EPS is 5 x 2 + 10 x 1 = 20. The new PE ratio now is 400/20 = 20!

The EPS jumped from 16 to 20 overnight with absolutely no changes in the fundamentals of any company in the market.

Most indices are rebalanced every 3 or 6 months, when companies get added and deleted from indices according to the predetermined rules. Depending on the description of the index more value or growth stocks enter indices with changes in market cycles. Failing to adjust PE leads to misinformation and unwarranted panic or greed in the minds of the investors who rely on this ratio.

Following the same principles as index rebalances, I’ve adjusted and normalised the PE ratio of the Nifty Midcap 50 Index using data published by the NSE. The chart below shows the difference between NSE published and the adjusted PE ratio since 2006.

The same chart when done from 2014 looks something like this.

And from the beginning of 2016 looks a bit like this.

Clearly buying and selling blindly based on the published PE is quite stupid. If we’re looking at an index like the S&P 500, the addition and deletion of 5–10 companies will have minimal impact. However, when you look at a Indian index with just 50 names, the jumps can be very large and can cause irreparable damage to portfolios that blindly follow rules based on the PE value.

Please remember that the PE chart you see everywhere is a discontinuous series. Using it to look for trends can be dangerous!

You can download the NSE published PE data here.