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A Study on Evaluating P/E and its Relationship with the Return for NIFTY

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 www.ijird.com June, 2016 Vol 5 Issue 7

ISSN 2278 – 0211 (Online)

A Study on Evaluating P/E and its Relationship with the Return for NIFTY
Dr. Hemendra Gupta
Assistant Professor, Jaipuria Institute of Management, Lucknow, India

Abstract:
Retail Investors have always been in doldrums in deciding about the timing of entry and exit in market. These investors at large
are driven by emotions in investing and are swayed by sentiments prevailing in market and thus at times entering into market
when valuations are on higher side which is a time of euphoria and exiting the market when valuations are low and there is
feeling of despondency. To understand this dilemma PE metric is one such valuation ratio. The paper explores the PE of NIFTY
as an opportunity to invest and to identify and predict the expected return which can be earned based upon historical data. The
paper also explores whether there is any difference in expected return if investment is made at different PE level of NIFTY.

Keywords: PE ratio, NIFTY, Market Capitalization

1. Introduction
For retail investor it has always been a cause of concern timing their investments in equity market in terms of entry and exit from the
market and deciding about valuation of market. On what basis one can decide the valuation of Stock market (NIFTY) and whether the
current level is too high, high or fairly reasonable. One of the common bases for valuation is P/E ratio.
The Nifty 50 is the flagship index on the National Stock Exchange of India Ltd. (NSE). The Index tracks the behavior of a portfolio of
blue chip companies, the largest and most liquid Indian securities. It includes 50 of the approximately 1600 companies listed on the
NSE, captures approximately 65% of its float adjusted market capitalization and is a true reflection of the Indian stock market. The
Nifty 50 is a diversified index, accurately reflecting the overall market. The reward-to-risk ratio of Nifty 50 is higher than other
leading indices, offering similar returns but at lesser risk.
PE ratio is one of the most widely used tools for stock selection. It is calculated by dividing the current market price of the stock by its
earning per share (EPS). It shows the sum of money you are ready to pay for each rupee worth of the earnings of the company.
In short, PE of a stock = Market price of share/ Earnings per share. If the market price of a company on a given day is Rs 500 and its
EPS is Rs 100 the PE ratio of that stock would be 5. While EPS of a company remains the same for a period or quarter (period of three
months) or a year, the market price of stock changes everyday and hence the P/E ratio also changes.
Nifty P/E ratio is calculated by dividing the sum of market capitalization by the sum of earnings of all companies which constitute the
S&P CNX Nifty. The ratio is a measure of how expensive the overall markets are at any given point of time. This ratio is based on two
variable – (a) price of the stock; and (b) earnings. Whenever price moves faster in relation to earnings, the PE number will go up.
The objective of the study was to examine the existence of P/E ratio anomaly in NIFTY and to investigate a potential low price-
earnings (P/E) investment strategy as a means of making good returns.

2. Review of Literature
The Review of literature in the concerned research area is of great importance in carrying out further research work. Robert A.
Weigand and Robert Irons talks about that High-P/E periods are preceded by accelerating equity returns and declines in both nominal
interest rates and stock market volatility. Following these periods, stock returns are marginally higher when earnings growth is strong
and interest rates continue falling. In particular, high-P/E periods triggered by temporary earnings declines are followed by low
positive stock returns, but returns are negative for at least a decade when earnings grow rapidly and the market P/E climbs above 20.
Following both types of high-P/E events, however, real stock returns are appreciably lower than average for the subsequent decade.
Basu’s (1977-1985) has done an empirical study and finds that companies with low P/E ratios on average earn higher absolute and
risk-adjusted rates of return than higher P/E portfolios. He examines the common stock of more than 1300 industrial firms, listed on
the New York Stock Exchange (NYSE) for the period between 1957 and 1971. Stocks in report were ranked by E/P ratios (also
referred as earnings yield) and then dividing into quintiles.
Damodaran (2006) mentions that other things held constant, higher growth firms should have higher PE ratios than lower growth
firms. Other things held same, higher risk firms will have lower PE ratios than lower risk firms and other things held equal, firms with
lower reinvestment needs will have higher PE ratios than firms with higher reinvestment rates. However, he also mentions that other
things remaining constant are difficult to hold equal since high growth firms tend to have risk and high reinvestment rates

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Keith P. Anderson (2005) the p/e ratio is used widely to measure the expected performance of companies. However, the P/E of a stock
is partly determined by outside influences such as the year in which it is measured, the size of company, and the sector in which
company operates. He divided companies into five groups by keeping P/E as a base. He found that average return for 7years were
12.71% per annum (131% total) for the companies with a P/E less than 10. At the same time, it was 7 97% for those stocks with P/E
over 20. He concluded that the purchaser of common stocks may logically seek the greater productivity represented by stocks with
low rather than high price earnings ratios
Defining the P/E ratio as the market price per share divided by earnings per share, Chisholm (2009) focuses on the P/E ratio and is
used to rate which shares in a given sector are dear and cheap to each other. It is possible to compare the P/E ratios of similar
companies, which are in similar line of business and their performance is affected by the same kinds of factors. There is a problem in
case of companies making business in different sectors. To value stocks, different accounting standards are often used, too. Many
investors are prepared to pay a premium for high growth expectations in the form of a high P/E ratio. P/E ratios are affected by the
general level of market interest rates as the changes in interest rates tend to have an effect on corporate earnings.

3. Research Methodology
Study has been conducted for the period from April 1999 to April 2015 and data for the same has been taken from NSE website and
data of 3993 days has been analyzed. Return has been calculated for different period at various P/E level to estimate the model. One
Way ANOVA Test has been used to find test whether return generated by NIFTY is independent of PE value. Regression Model has
been run to build relationship of P/E and return for different period.

4. Findings of Study
For the period of Study which is for 3993days NIFTY, average P/E has been 18.59 with the lowest P/E which was observed on Oct
2008 as 10.68 and the highest P/E was seen on Jan 2008 at 28.23 and also February 2000 at 28.47 the market has been in this range.
As seen from the Table 1and Figurer1on 42.6% trading days the PE was in the range of 18-22

P/E No. of Days Probability

10_12 55 1.4%
12_14 320 8.0%
14_16 636 15.9%
16_18 676 16.9%
18_20 845 21.2%
20_22 856 21.4%
22_24 403 10.1%
>24 202 5.1%
Table 1

21.16% 21.44%

15.93% 16.93%

10.09%
8.01%
5.06%
1.38%

10_12 12_14 14_16 16_18 18_20 20_22 22_24 >24

P/E Range

Figure 1: Probability Distribution of PE Ranges of NIFTY for Period 1999- 2015

As observed from Table 1 there were 55 days which is 1.38% of time when the PE was in range of 10-12 and if on these days’
investment is made then average return for one year has been 68.84% as seen in Table 2 whereas for a period of 10 years the average
return has been 19.35%.
This is in contrast if investor invests when the PE> 24 even for a period of 10 years the average return has been 12.26%. It thus seems
that return even for both short term and long term is getting impacted by the time when the investment was made
Testing hypothesis that Investment return is not impacted by P/E value at the time of investment in market it was observed by
applying ANOVA that for investment horizon for one, two, three, five and ten years’ hypothesis is rejected and conclusion is drawn
investment return are dependent upon P/E of market and also as observed from the table however for investment period of seven years
it was observed that average return is independent from PE of market

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On further analyzing from table 3 it is observed that if investor gets an opportunity to invest in the PE range of 10-12 the probability
of loss is zero for any investment period of more than one year and the minimum return to be earned is more than 35% for a year and
17.5% for ten-year period and this is an exception return
As 42.6% the probability has been that PE will be in range between 18-22 and if an investor invests in this period the probability of
loss is zero if investment horizon is five years and more and if invests for 10 years then minimum return earned was 11.7%
There has been 5.1% chance that PE was more than 24 and if an investor has invested at these occasions probability of loss would
have been zero for investment period of 7 years or more and for 10-year investment period the minimum return was 10.7%

One Year Return Two Year return

P/E Average Variance F P-value Average Variance F P-value
10 --12 68.8% 0.042081 541.4384 0 44.6% 0.00129 832.0756 0
12--14 55.4% 0.064841 40.6% 0.002895
14--16 34.5% 0.067243 31.1% 0.020926
16--18 21.6% 0.028313 20.2% 0.02021
18--20 10.3% 0.026869 10.6% 0.017151
20--22 4.6% 0.051304 0.1% 0.016514
22--24 -7.2% 0.036409 -4.4% 0.00415
>24 -30.5% 0.023534 -9.7% 0.00349
Three Year Return Five Year Return
P/E Average Variance F P-value Average Variance F P-value
10 --12 40.6% 0.017312 743.6795 0 29.7% 0.008479 614.3963 0
12--14 33.5% 0.010421 24.6% 0.004906
14--16 26.7% 0.00657 26.7% 0.00657
16--18 16.0% 0.014039 16.8% 0.00657
18--20 11.6% 0.008735 11.7% 0.005288
20--22 5.9% 0.008718 7.7% 0.00147
22--24 0.8% 0.003544 8.2% 0.001464
>24 -5.1% 0.004727 2.7% 0.000698
Seven Year Return Ten Year Return
P/E Average Variance F P-value Average Variance F P-value
10 --12 25.3% 0.000635 144.2409 1.1E-175 19.35% 0.000111 396.326 0
12--14 20.4% 0.002162 17.91% 9.61E-05
14--16 19.3% 0.002668 17.21% 0.00019
16--18 16.1% 0.002888 15.88% 0.000185
18--20 14.4% 0.003613 15.44% 0.000234
20--22 12.4% 0.002504 13.88% 0.000112
22--24 14.0% 0.002087 13.78% 3.18E-05
>24 9.8% 0.001791 12.26% 6.85E-05
Table 2

PE 10-12 PE 12-14
Period(Yrs.) 1 2 3 5 7 10 Period(Yrs.) 1 2 3 5 7 10
count 55 55 55 55 39 39 count 320 320 320 320 233 186
average 68.8% 44.6% 40.6% 29.7% 25.3% 19.3% average 55.4% 40.6% 33.5% 24.6% 20.4% 17.9%
Max 100.1% 55.7% 58.4% 41.0% 27.3% 20.7% Max 104.4% 58.1% 56.4% 43.7% 27.5% 20.6%
Min 39.3% 39.4% 20.5% 17.4% 19.9% 17.5% Min -1.5% 15.8% 10.8% 13.4% 12.8% 15.6%
<0% 0 0 0 0 0 0 <0% 4 0 0 0 0 0
0-10% 0 0 0 0 0 0 0-10% 17 0 0 0 0 0
10-20% 0 0 0 16 1 23 10-20% 5 1 37 86 116 177
>20% 55 55 55 39 38 16 >20% 294 319 283 234 117 9
PE 14-16 PE 16-18
Period(Yrs.) 1 2 3 5 7 10 Period(Yrs.) 1 2 3 5 7 10
count 636 623 623 623 600 486 count 676 541 419 355 306 195
average 34.5% 31.1% 28.2% 26.7% 19.3% 17.2% average 21.6% 20.2% 16.0% 16.8% 16.1% 15.9%
Max 84.7% 57.6% 50.0% 45.0% 27.5% 19.9% Max 57.6% 51.3% 45.7% 33.0% 26.1% 18.3%
-
Min -12.2% -9.3% 0.5% 11.8% 11.1% 13.5% Min -18.3% 13.2% -5.0% 3.6% 7.6% 12.1%
<0% 125 35 0 0 0 0 <0% 93 71 54 0 0 0
0-10% 41 44 45 0 0 0 0-10% 77 23 67 81 43 0
10-20% 21 31 126 150 293 486 10-20% 136 116 141 166 152 195
>20% 449 513 452 473 307 0 >20% 370 331 157 108 111 0

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PE 18-20 PE 20-22
Period(Yrs.) 1 2 3 5 7 10 Period(Yrs.) 1 2 3 5 7 10
count 822 717 589 468 382 216 count 695 695 695 553 409 209
average 10.3% 10.6% 11.6% 11.7% 14.4% 15.4% average 4.6% 0.1% 5.9% 7.7% 12.4% 13.9%
Max 62.7% 42.5% 34.6% 30.4% 26.1% 18.1% Max 61.5% 40.0% 32.3% 18.6% 24.5% 16.4%
Min -35.6% - - 2.9% 6.0% 11.7% Min -50.0% - - 2.1% 5.7% 12.2%
20.8% 11.0% 21.2% 13.6%
<0% 183 150 68 0 0 0 <0% 325 300 130 0 0 0
0-10% 244 172 197 223 162 0 0-10% 116 291 404 367 200 0
10-20% 147 205 226 189 131 216 10-20% 121 40 103 186 185 209
>20% 248 190 98 56 89 0 >20% 133 64 58 0 24 0
PE 22-24 PE >24
Period(Yrs.) 1 2 3 5 7 10 Period(Yrs.) 1 2 3 5 7 10
count 336 336 336 213 116 83 count 201 201 201 148 148 78
average -7.2% -4.4% 0.8% 8.2% 14.0% 13.8% average -30.5% -9.7% -5.1% 2.7% 9.8% 12.3%
Max 26.1% 28.6% 25.9% 17.2% 22.1% 15.2% Max -11.3% 0.1% 5.6% 7.8% 16.5% 13.7%
Min -51.3% - - 0.8% 6.8% 12.8% Min -56.8% - - -1.0% 4.7% 10.7%
19.6% 15.0% 19.0% 16.5%
<0% 203 271 82 0 0 0 <0% 201 200 135 30 0 0
0-10% 54 64 243 134 33 0 0-10% 0 1 66 118 70 0
10-20% 54 0 10 79 73 83 10-20% 0 0 0 0 78 78
>20% 25 1 1 0 10 0 >20% 0 0 0 0 0 0
Table 3: Evaluation of Return of NIFTY at various P/E level

As expected as seen from table 4 the correlation between PE and expected return is negative irrespective of horizon of investment
period and is less than -0.7 for investment period till five years
Regression model (Table 4) is framed to forecast the returns based upon the investment horizon in most of the cases the model is able
to explain more than 50% variation (as shown by Rsquared values) on return on taking PE as independent variable to forecast return

𝑂𝑛𝑒 𝑌𝑒𝑎𝑟 𝑅𝑒𝑡𝑢𝑟𝑛 = 1.293 − 0.061𝑃𝐸 + 𝑒

𝑇𝑤𝑜 𝑌𝑒𝑎𝑟 𝑅𝑒𝑡𝑢𝑟𝑛 = 0.965 − 0.045𝑃𝐸 + 𝑒
𝑇ℎ𝑟𝑒𝑒 𝑌𝑒𝑎𝑟 𝑅𝑒𝑡𝑢𝑟𝑛 = 0.759 − 0.033𝑃𝐸 + 𝑒
𝐹𝑖𝑣𝑒 𝑌𝑒𝑎𝑟 𝑅𝑒𝑡𝑢𝑟𝑛 = 0.55 − 0.021𝑃𝐸 + 𝑒
𝑆𝑒𝑣𝑒𝑛 𝑌𝑒𝑎𝑟 𝑅𝑒𝑡𝑢𝑟𝑛 = 0.324 − 0.099𝑃𝐸 + 𝑒
𝑇𝑒𝑛 𝑌𝑒𝑎𝑟 𝑅𝑒𝑡𝑢𝑟𝑛 = 0.227 − 0.004𝑃𝐸 + 𝑒

As seen by regression Models for alpha coefficient is decreasing as the time horizon is increasing thereby also indicating that as
investment period is increased the expected return dependency on PE is decreasing however the earlier table of ANOVA has shown
that the returns are dependent on PE value at the time of investment
In the study attempt has also been made to find an opportunity of investment when there is major fall in market and for the given
period of the study there have been nine occasion (Table 5)which have been identified when the market has fallen from making a peak
and biggest fall after attaining a certain peak(Figurer 2) in NIFTY was in Sep 2001 when NIFTY fell by 38.6% and PE of NIFTY
decline by 45.9% and making investment at this time yield a return of 13.6% for a year and return of 27.1% for three years
In terms of return Table 5 the best opportunity was observed in April 2003 when NIFTY shown a decline in 13.7% and investing at
this time yielded a return of 93.5% for a year and 52.7% for three years. The findings of Table 5 show that the market gives an
opportunity for making abnormal return for a period of one to three years

Regression Analysis of Return Vs PE

Year Correlation Constant Coefficient R Squared F value Sign
1 -0.714 1.293 -0.061 0.51 4063.6 0.00
2 -0.793 0.965 -0.045 0.629 6200.2 0.00
3 -0.771 0.759 -0.033 0.594 4988.0 0.00
5 -0.762 0.55 -0.021 0.58 4011.7 0.00
7 -0.54 0.324 -0.009 0.291 986.5 0.00
10 -0.665 0.227 -0.004 0.442 1313.8 0.00
Table 4

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30 9.9
NIFTY Vs P/E

Thousands
28 8.9
26 P/E close 7.9
24
P 22 6.9
5.9
/ 20
4.9
E 18 3.9 N
16
14 2.9 I
12 1.9 F
10 0.9 T
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Y

Figure 2

Return after Major Fall in NIFTY

Peak Bottom Change CAGR Return
% Fall % Fall Two Three
Date NIFTY P/E Date NIFTY P/E NIFTY PE One year Years Years
9-Feb-01 1391.2 22.73 21-Sep-01 854.1 12.3 -38.6% -45.9% 13.6% 28.8% 27.1%
26-Feb-02 1189.4 19.14 28-Oct-02 922.7 14.03 -22.4% -26.7% 60.6% 38.9% 37.4%
1-Jan-03 1100.15 14.92 11-Apr-03 949.8 12.97 -13.7% -13.1% 93.5% 45.4% 52.7%
6-May-04 1832.8 17.04 17-May-04 1388.75 12.87 -24.2% -24.5% 43.2% 52.9% 45.3%
10-May-06 3754.25 21.28 14-Jun-06 2632.8 14.92 -29.9% -29.9% 57.5% 28.5% 18.9%
7-Jan-08 6287.5 28.25 19-Mar-08 4503 19.93 -28.4% -29.5% -28.8% 6.9% 8.9%
1-Oct-08 3950.75 16.98 24-Oct-08 2943.1 10.99 -25.5% -35.3% 93.7% 53.3% 24.1%
3-Jan-11 6157.6 24.57 16-Dec-11 4544 16.46 -26.2% -33.0% 25.9% 16.1% 21.2%
1-May-13 6187 18.38 27-Aug-13 5302 15.3 -14.3% -16.8% 53.5% 21.4%
Table 5

5. Conclusion
As per the findings it can be observed that market (NIFTY) has provides opportunity for investor to earn super normal returns and in
future also these opportunities can be expected and the PE of NIFTY definitely is an indicator which need to be looked upon for
investment.
However, it need to be observed that few things can distort P/E ratio as companies that have recently sold off a business can have an
artificially inflated earnings and a lower P/E as a result. A firm may book a big one time gain from the sale of a division which can
boost reported earnings, but based on operating earnings, the stock may not be cheap at all.
Besides that, reported earnings can sometimes be inflated (or depressed) by one-time accounting gains (or charges). As a result, the
P/E ratio can be misleadingly high or low. For example, a company’s earnings can be depressed due to a onetime charge for litigation
or other extraordinary expense and this may in turn give the stock what appears to be a sky-high trailing P/E.
These distortions in earnings in company can further distort the PE of Nifty also and thus impacting valuation of market in giving its
right picture. However, since we are taking the composite of 50 companies of NIFTY to large extent these distortions are discounted
and the models can give a fair view of returns which can be expected from market

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One Year Return Vs Two Year Return Vs

120% PE 70.0% PE
100% 60.0%
80% 50.0%
60% 40.0%
40% 30.0%
20% 20.0%
0% 10.0%
-20% 0 10 20 30 0.0%
-40% -10.0% 0 5 10 15 20 25 30
-60% -20.0%
-80% -30.0%

Three Year Return Vs Five Year Return Vs

70.0%
PE 50.0%
PE
60.0%
50.0% 40.0%
40.0% 30.0%
30.0%
20.0% 20.0%
10.0%
0.0% 10.0%
-10.0% 0 10 20 30 0.0%
-20.0% 0 5 10 15 20 25 30
-30.0% -10.0%

Seven Year Return Vs Ten Year Return Vs

30.0%
PE 25.0%
PE

25.0% 20.0%
20.0%
15.0%
15.0%
10.0%
10.0%
5.0% 5.0%

0.0% 0.0%
0 10 20 30 0 5 10 15 20 25 30

Figure 6: Return of NIFTY Vs PE for various Time periods

6. References
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ISBN 978-0-470-75898-4.
iv. Damodaran A (2006) Damodaran on Valuation, Wiley Finance
v. Gupta Hemendra, A Study on performance of Sensex and evaluation of investing lump sum or monthly regular investment in
equity on risk and return for investor, International Journal of Development Research Vol. 5, Issue, 04, pp. 4323-4327, April,
2015
vi. Harri Ramcharran (2002), An empirical analysis of the determinants of the P/E ratio in emerging markets.

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 www.ijird.com June, 2016 Vol 5 Issue 7

vii. Ilmanen, Antti, (2011) Expected Returns: An Investor’s Guide to Harvesting Market Rewards.
viii. Chichester, U.K.: John Wiley & Sons.
ix. Keith P. Anderson (2005), Decomposing the Price-Earnings Ratio.
x. Lambros Stefanis (2005), Testing the Relation between Price-to- Earnings Ratio and Stock Returns in the Athens Stock
Exchange. |
xi. Nicholson, S.F., (1968), “Price-Earnings Ratios in relation to Investment Results” Financial Analysts Journal: 105-09.
xii. Penman, S. 1996. The Articulation of Price-Earnings Ratios and Market-to-Book Ratios and the
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xiv. Robert A. Weigand and Robert Irons, The Journal of Portfolio Management · January 2007, The Market P/E Ratio, Earnings
Trends, and Stock Return Forecasts

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