Thread by @vipuls1979

Thread on PE and Valuations of NIFTY 50 PE.
I have made it easy for beginner to understand

P/E ratio simply means how much money you are paying to generate 1% returns.
For Example: If a share is quoting at P/E 25, it means you are paying Rs 25 to earn 1 from that company.
(1/n)

You must have heard abt “Over Valued”, ‘Expensive” and “Under Valued”, what is the rationale behind the above statement.
Let us explore
Imagine u purchased RBI Bond with an interest of 7.75%.
It means you pay 100 & u get ₹ 7.75 as interest credited in your bank account (2/n)

Price to Earning: Market Value / Earnings Per Share
In our GOI bond’s case: Market Value is ₹ 100 and Earning is ₹ 7.75

P/E ratio = 100 / 7.75 = 12.90

12.90 is the benchmark to compare whether markets are overvalued or undervalued.
(3/n)

How do we determine fair value of markets?

When invested in markets, taking risk of uncertainty, I shall get more than RBI Bonds returns a.k.a risk free returns.

Equity Returns [ 100/ Market P/E ] >Risk free return

By re-arranging the above. Market P/E < [100/RISK Free]
(4/n)

Gains from equity investments are 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 v want 2 remove impact of dividends which we will receive YoY (5/n)

Market P/E < [ 100/ (Risk Free Returns – Dividend Yield) ]
The above calculation is for Current/Historic PE ratio, I am of the opinion that while investing today v s'd incorporate expected earnings growth.

Market P/E<[ 100/ (Risk Free–Dividend Yield)]x(1+earnings growth)
(6/n)

Fair Market P/E = (100/ (7.75-1.25)) X (1+12%)

Fair Market Valuation = 17.23

In the above equation, Risk Free Interest rate is considered as 7.75% RBI Bonds, dividend yield as 1.25 and expected growth from equities at 12%

If market P/E is > fair market valuation, (7/n)

it is advisable to have a larger portion to debt and when it falls above the range of 1 Standard Deviation or at fair market PE, advisable to invest more in equities
Below image depicts the PE 1 & 2 Standard Deviation from Fair Price calculated as on 28th Feb 2020
(8/n)

If u closely observe the chart, you will see whenever markets crossed 2 STDEV, it fell sharply.

Increase your allocation to equities when NIFTY 50 PE ratio is below fair PE (Yellow Line) & its a screaming buy when it is 2 STDEV below the fair price like in 2008-2009
(9/n)

Today NIFTY 50 PE is at 18.40 which is in reasonable valuation if compared to RBI Bonds

Have any questions happy to address those.............