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How Low PE Investing Works
Fri, 16 Oct Pre-Open

Valuations play a crucial role in determining the worth of a company. They provide an up-to-date view of the value of the business. For an investor, the crux behind finding the value of a business is for the purpose of decision making. It provides one with a figure that can be compared with the current market price and thus facilitates investment decisions.

If the value of the business seems lower than its price, it's obviously good to ignore that business. On the other hand, if valuations are low, there is scope for stock price appreciation. That's what long-term value investors focus on. The benefit here is twofold: First, acquisition costs are lower. Second, there's room to generate higher long-term returns.

While this philosophy is well known, few seem to truly understand the significant difference lower valuations make.

According to a study in the Business Standard, over the 10 years, the price-to-earnings (PE) ratio of the Nifty index has seen a high of 28.3 and a low of 10.7. An investor who bought the index when it was trading at a PE between 10 and 16 received a fantastic average compounded annual growth rate (CAGR) of 24.4%.

Investors who bought the index when it was trading at a PE between 16 and 19.5 received an averaged CAGR of 11.9%.

Those who bought between 19.5 and 22.5 received an averaged CAGR of just 6.5%.

And investors who bought between 22.5 and 25.5 received an averaged CAGR of mere 2.1%.

Returns were highest when the index was at lower PE levels. As the valuations started to rise, returns decreased.

The conclusion is that the lower the valuation at acquisition, the better the long-term return. While this might seem insignificant for long-term investors, it can make all the difference in the world.

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Mar 21, 2018 (Close)