Recently we wrote that it could potentially be a good time to buy by purely looking at the recent performance. This was based on the principal of mean-reversion. Periods with low trailing return are followed with period of high return and vice-versa. Here we delve into the valuations of NIFTY. While valuation alone can’t predict the future returns but they can definitely be used to gauge downside risks. Normally, big fall in markets take place when valuations are near their peak. It was actually the case till few months back. We are using the P/E ratio, P/B and dividend yield to gauge the NIFTY valuation. The values for these metrics are downloaded from NSE website.
P/E ratio is simply the ratio of the price of the index and the earnings of the index. The latest ratio is 20.3 wjich is below the historical average of 20.8. This means that the current valuation of index is slightly better than its history.
P/B ratio is the ratio of the price of the index and the accounting value of investments made to generate earnings. Stocks in the index issue the shares and also retain a portion of the earnings after paying dividends. Book value of the share is simply the equity capital issued and the retained earnings. The latest P/B ratio is 4.2 which is above the historical average. On this metric, the index is a bit expensive compared to historical mean.
Dividend is the amount paid back to investors from the earnings. Dividend yield is simply ratio of the dividends and share price. The current dividend yield is1.4 and this is near the historical average.
So, based on 2 out of three valuation parameters, valuation of the index is near or better than historical average.
What to do in current scenario?
When valuations are near or better than historical average, one should expect return that should be in line or potentially better than historical average. Based on the data since 2004, average 5 year rolling return of the index has been 13.8% (including dividends it could be around 15%). While past is never exactly repeated, it can give us an idea to anchor our expectations.
Based on current valuations and trailing return, it may be prudent to keep investing in equity mutual funds in systematic manner and in fact boost the same if we see some correction in the index from current levels.
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