Today I am going to share with you, how PE ratio is related to sensex movement. Also how we can interpretate the relation between the two. Before proceeding further want to make you comfortable with PE ratio.
PE ratio is nothing but Price to Earning ratio of stock or Index. Hence formula to calculate it is, Price of Stock/EPS (Earning Per Share). Earning Per Share can be calculated usually on quarterly base as companies declare their Earnings on Quarterly base. EPS can be calculated as Net Profit of the Company/No. of outstanding shares. In the same way Sensex, NSE or any Index have their own PE ratio which shows values of underlying stocks.
PE ratio usually indicates how much it is overvalued or undervalued. Suppose PE of Stock X is 20 means, investors are ready to pay Rs.20 for each rupee earning of Stock X. Hence low PE usually considered as best undervalued stock. Now I think you are familiar with PE ratio.
We will now look into the relation between PE ratio and Sensex movement of last 21 yrs.
Sensex movement from 1991 to 2012
PE Ratio of Sensex from 1991 to 2012
By comparing the above two charts you can just see how PE is actually followed Sensex and indicated whether Sensex is over valued or undervalued. Usually Sensex is considered overvalued whenever PE is above 25. Middle path is from 25 to 15 and undervalued when it is below 15.
Now to give you clear idea how PE showed sensex valuation is in below table.
It may not be the only indicator to judge market, but definitely history shows that PE has given us opportunity to invest in Equity market when it is low.
Hope you got the point what I am stressing at this juncture of market. Happy Saving!!!