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Sensex and PEG ratio: Are valuations justified?

Jan 22, 2013

PEG ratio is the P/E ratio dividend by the EPS growth of a company. The general thumb rule is that an investor should avoid buying into a company when the PEG ratio is in excess of one. What this means is that the valuations should be justified by the earnings growth. As stated by Peter Lynch, "The P/E Ratio of any company that's fairly priced will equal is growth rate".

We shall apply this logic for the BSE-Sensex. We will take a look at two things - the P/E ratio of the Sensex and the index's year on year change in earnings per share. We have compared these parameters for two five year periods - one ended 2007 and the other starting 2008.

If we see the Sensex P/E ratio over the long term, it has averaged at about 18.5 times. Going by the logic of the PEG, the P/E ratio would be justified if the earnings growth rate was in excess of this figure. This seems to have been the situation prior to 2007.

Data source: ACE Equity

As you can see, the Sensex EPS was volatile (may not be a 100% accurate due to the method we have calculated the EPS growth; at the same time, the extreme volatilities may be due to non-adjustment of extraordinary items, change in the index constituents, amongst others) during this period, but it would be fair to assume that the growth rates were in excess of 18.5%. Taking an average of the EPS growth during the period, it stood at nearly 27%. The average P/E during this period stood at about 18.2 times.

Now let us move on to the period post 2007 i.e. from 2008 till present. The scenario changes quite a bit. And this at a time when the general view (including ours) was that the overall markets are attractive considering that the benchmark index is trading below its long term average P/E ratio. But when we apply the above mentioned logic, it does seem to paint a slightly different picture.

Data source: ACE Equity

As you can see, unlike the pre-2007 era, the EPS growth rates declined or reduced substantially. While the earnings growth rates have improved off late, they still stand below the average growth rates during the period 2003 to 2007.

With these data points, it does seem like the argument about the Sensex being attractive especially when compared to the historical valuations does not hold true.

So, are Sensex stocks expensive?

Ideally, the PEG ratio should not be applied to an index which has a basket of stocks from different sectors - including those from cyclical industries/businesses. The ratio is useful to compare two firms in the same industry with similar fundamentals and also in some sense for companies with steady growth levels. As such, based on this analysis one cannot conclude that all Sensex stocks are expensive at current valuations.

Do note...

You can now view P/E and P/BV graphs of India's leading corporates on Equitymaster...

Not just that, you can also see for instance how the valuations of Infosys compare with TCS over the last 3 years!

Start here with the valuation chart for Infosys...

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