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Value of PE Ratio in buying equity shares

A lot has been said and written about Price-Earning Ratio (PE Ratio). It is one of the key qualities of an equity share that can deliver stunning returns.

Logically, lower the PE ratio, cheaper is the share. [However, beware! As I had explained in an earlier blog PEG Ratio demystified!, not every cheap stock is a good buy. Hence, you should not jump into any stock just because it has a low PE ratio.] This is one part of the story.

The second part is whether this fact has also actually translated in reality or not.

To ascertain this, I did some number crunching.

Beginning from 1999 onwards, I calculated what would have been our 3-years returns if we had bought the Nifty on any given day. As I had to work out the returns over a 3-year period, I assumed investment up to Sept 2011. There were around 3200 trading days during this period.

I compared this with the PE ratio of market as on that date and made a graph co-relating PE ratio with the 3-year returns. As you can see, there is a strong and significant negative co-relation between the two.

Buying stocks when the market PE ratios were at elevated levels, typically resulted in very poor or even negative returns. In contrast, we would have earned handsome returns if we had made our investments when the PE levels were down.

Extrapolating this to today... 

Market is currently trading at 20+ PE levels. This, as historical data shows, can prove disastrous — unless, as explained in the PEG Ratio blog, there is a sustained economic growth over the next few years.

Remember: In stock markets there is no Certainty, there is only Probability.

Therefore, as a matter of abundant precaution, today one may avoid investing in the broader market. Instead, focusing one's attention on specific stocks could bring in much better results even if the markets as a whole are relatively expensive.

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