Using the most common valuation metric, the price to earnings ratio, it helps knowing how companies are valued on a relative basis. If the result throws up a high number, it can be said that the expectations from a particular company are high and as such investors are willing to pay a high price per unit to attain it. The same is the case for the vice versa.
For an investor, a good practice is to compare this valuation metric with that of its respective index. This helps in knowing where the company stands as compared to the sector or the industry as a whole. For example, one would compare the price to earnings multiple of Infosys' stock to that of the BSE Sensex (industry) or to that of the BSE IT index (sector).
It may be noted that at first sight, a particular company's stock could look valued below, at par or above the respective index's value. It is always recommended for an investor to look into the reason to why a particular stock is valued at that multiple.
Sensex and its historical valuation
The BSE Sensex has a long history of valuations during different phases. As you can see in the chart below, we have taken the price and valuation of the BSE Sensex since 1991.
During the run ups in 1992 and 1994, the BSE Sensex touched mind boggling price to earnings ratios of 50 times. However, post this period, valuations remained very volatile on account of the securities breakout scam (1992) and the subsequent bounce back (1994). Following the Asian crisis, post 1997, valuations took a major fall on worries of a global economic slowdown. During October 1998, the BSE Sensex touched valuations of around 10 times.
During the tech bubble and its subsequent burst, the BSE Sensex's valuation slumped from 30 times (at its peak) to 20 times in a matter of months. Thereafter, the valuations dropped to lower levels. Post 2002, the Indian economy started witnessing a turnaround on account of favourable economic reforms.
In its last bull run, the BSE Sensex touched a price to earnings multiple of 27 times at the end of 2007 (peak). At present the valuation of the BSE Sensex stands at an approximate of 12.3 times.
Looking at its eighteen years history, the BSE Sensex does definitely look very attractive at current valuations. However, considering the overall economic picture, questions such as, whether the market has bottomed out still remains unanswered. Sure, the markets might go lower but if a person's investment horizon is 3-5 years, then the odds that he will come out of the period with a loss are very low.