Can PE Level Predict Future Returns Of The Stock Market?

Warren Buffett, one of the most successful American investors, once said, “Price is what you pay. Value is what you get”. What this means is that the returns on any investment are heavily dependent upon the price you pay to acquire that asset. Equity investment is no exception to this, and the future returns of equity depend upon the price you paid to buy it. If you have bought equity at a reasonable price, your returns are likely to be good.

One of the best ways to determine the right price of equity is to use the various valuation matrices like dividend yield, price-to-book value or price-to-earnings (PE) ratio. Of these, the most widely used metric is the PE ratio. Although there are many versions of PE, we used the current PE at the end of the financial year to learn about its predictive power for future returns.

Methodology

For our study, we have used the Sensex data for the past 21 years ending 2013. The PE ratio in this period varied from 11x to 29x. We divided the entire PE ratio into four quartiles (See table) and tried to gauge if a lower PE meant higher returns going forward. Based on this, we calculated returns for the next 5 years.

For example, at the end of FY03, the PE for the Sensex was 11.21x; this lies in our first quartile. Then, we calculated the CAGR given by Sensex over the next 5 years ending FY08. The index moved up from 3048.72 to 15626.62 in the period, yielding an annualised return of 50%. We repeated this process for the entire period.

Findings

The result of our study confirms the inverse relation of PE with future stock returns. The average future returns generated by the first quartile PE are more than that in the second quartile, the second quartile PE generated more returns than that in the third quartile, and so on (See table).

One of the reasons for such a performance is the mean reverting relation of equity returns. This means that the stock’s high and low prices are temporary and will tend to move to the average over a period of time. However, this is applicable for the longer duration only, as for shorter horizons the prices may remain at the elevated or suppressed levels.

Currently, Sensex is trading at a PE of 17.57x, which lies in the third quartile of our study. This means an average 14% returns in the next 5 years.