“We are not so brazen as to believe that we can perfectly calibrate valuations; determining risk and return for any investment remains an art not an exact science.” Seth Klarman
None of us can predict the future still we try to, this is basic human nature. Though our predictions can be put across with probability to show our confidence on the predictions. If empirically we have seen only 1-2% people stay alive beyond the age of 100, we can say that with 98% probability that one will die before the age of 100. I am here not to talk about probability but to re-emphasize my love for P/E ratios to predict the future of equity market and stock valuations. 7 years back i wrote about “PE Ratio: Essential or Controversial” method while selecting a stock. In the write-up i suggested some basic ways to find stock and stick to it for long term. Those who followed might have got 10x returns in 7 years, others still searching for the holy grail of investments in stocks. Today, we are not to hunt the best stocks but to design the overall portfolio and also apply the same for people using Mutual Funds to build their portfolio. We will understand the P/E ratios, calculate its fair value and try to predict the market valuation to determine our equity allocation in the Portfolio. This is a continuation to “How much equity should you hold?“
What does P/E ratio means & its interpretation?
P/E ratio is simply price per share divided by the earnings per share. If the P/E ratio for a stock is 10, it means that for 10 rs investment you should expect 1 rs earning. Since the buying of stock of a company makes you the owner and earnings are your return/ profit, you can say for 10 rs investment you are getting 10% returns. Your %returns can be calculated by (100/ P/E ratio). Therefore for a company when a P/E is 16, your return expectations should be 6.25% (100/16).
What is fair P/E value of Market?
Fair P/E value of market is very complex and can depend on the various parameters. for the sake of simplicity, i will say the Market P/E ratios should be providing us return better than yield on government bonds a.k.a. risk free returns.
Equity Returns [ 100/ Market P/E ] > Risk free return (Govt. Bond Yields or Repo rate)
By re-arranging the above inequality. Market P/E < [ 100/ Govt. Bond Yields ]
We usually receive the gains/ returns from equity investments in two forms; dividends and capital appreciation. Dividends are usually sticky as well as restricted to the amount that it does not impact companies earning capabilities. So if we want to remove the impact of dividends which we will receive on a year on year basis.
Market P/E < [ 100/ (Govt. Bond Yields – Dividend Yield) ]
The above calculation is for Current/Historic PE ratio, Some people will argue that while investing today what we should incorporate the expected earnings growth.
Market P/E < [ 100/ (Govt. Bond Yields – Dividend Yield) ] x (1+ earnings growth)
Based on the above inequality, there are following relationships:
- If the Govt. Bond yield is higher, Fair P/E ratio should be lower and vice versa
- If Dividend yield is higher, Fair P/E ratio should be higher
- If Expected earnings growth for market is higher, Fair P/E ratio should be higher
Let’s calculate the Fair P/E in current scenario; Govt Bond Yields (~8.0%), Nifty Dividend yields (~1.0%) and expected earnings growth of 20%.
Market P/E < [100/ (8-1) ] x (1+20%) ; Market P/E < 17.14
Every year the market scenario will change the Yields on Govt bonds will change, Dividend paying policies for Company will change as well as our expectations to the market. Based on new expectations, you should calibrate the Market P/E number. If all stays same, For Bond yields of 11% Market PE should be 12 while for bond yields at 6%, PE should be 24.
How to utilize this to determine your equity allocation?
As I do not have a crystal ball to tell future, There is no way for me to be 100% sure of market future except that it will fluctuate. As Ben Graham suggested in his book “The Intelligent Investor”, Never get out of market 100% or invest with market 100%. It can be always a mix. The range should be based on your risk capacity, risk appetite and time horizon for investments along with market valuations. Below is what i suggested to myself based on my risk profile; D stands for standard deviation and calculated for the P/E values starting Jan 2000.
This does not mean you should keep changing your equity allocation daily and keep tracking the market daily. This should be used for once or max twice a year to change your portfolio allocation. If you are not investing in equity, you should not stop saving but explore other venues like debt funds/ Gold investments or real estate etc. Saving/ Investment should not stop just change the asset class.
I have been using this for long, I have been saying that market is overvalued at least for last 4-5 quarters and i am not long on market. You can call me bearish and yes i am probably missing on the market growth, though I am sure in long term i will be better off. I can not stomach the fall of 5% in a month from 11,700 to 11,144 within a month. Hence aligning portfolio to risk profile is a must.