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IDFC AMC

Sensex PE

By: Punam Sharma

What is Price to earnings ratio (P/E)?
 

  • P/E is the price one pays for the earnings. It tells how much one is willing to pay per rupee of earnings.
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  • Suppose P/E is 20, it means that one is willing to pay 20 for a 1 earning.
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  • P/E is calculated as
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P/E = Current Price / EPS

 

  • P/E calculated by using actual EPS is known as trailing P/E and tells actual price paid for the earnings. P/E calculated using projected EPS is known as forward EPS and is the price one is willing to pay for expected earnings.
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  • P/E helps to understand whether the stock is cheap or expensive. High P/E means one is paying higher price for the earnings and low P/E means one is paying lower price for the earnings.
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  • Average P/E of Sensex is 15*.
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  • When Sensex trades much higher than its average PE, it will tend to revert back to its mean reducing Sensex value. Similarly when Sensex trades much lower than its mean# it will tend to revert back to its mean increasing index value.

 

Chart below shows Sensex trailing PE in various zones from March 2000.

 
Sensex PE

 

  • Average Sensex trailing PE is calculated from March 2000 till March 2013

    # Refer to ReWISE on Mean Reversion
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  • From the above chart, we can see Sensex has generally traded between 9 to 25 PE.
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  • Green zone is when Sensex is cheap and red zone when it’s expensive.
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  • When it’s traded much higher than average PE, it has reverted back to its mean which can be observed between 2005 and 2008.
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  • Similarly chart below plotted, shows Sensex value calculated with different PEs (15 and19 PE) and actual index value.

 
sensex pe band

 

Source: Bloomberg

 

  • Area above the red band is when index is overvalued and below green band is when index is undervalued.
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  • From above chart, we can see Sensex value has generally been between 15 and 19 PE.
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  • Only twice during 2000 and 2007 Sensex has traded above 19 times PE.
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What is PEG ratio?
 
 

  • P/E tells us whether Sensex is trading cheap or expensive relative to its earnings. However understanding P/E alone is not enough as the P/E needs to be justified with its earnings growth.
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  • Price/Earnings to Growth (PEG) ratio tell how the markets are valued on P/E and earnings growth. It’s calculated as below
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PEG = (P/E)/EPS Growth

 

  • P/E ratio which is fairly priced will equal its EPS growth rate and have a PEG equal to 1.This means the market is fairly valued.
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  • PEG greater than 1 means market is overvalued as P/E is highly priced compared to its EPS growth.
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  • PEG less than 1 means market is undervalued as P/E is cheaply priced compared to its EPS growth.
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  • Chart below shows Sensex PEG ratio on quarterly basis from March 2001.PEG ratio is calculated by dividing P/E ratio as on the quarter end by average EPS growth1 of 15%.
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sensex peg ratio

 

Source: Bloomberg

 

  • Green colour represents when PEG is less than 1 which means Sensex is undervalued. Yellow colour represents when Sensex is fairly valued while Red colour represents when overvaluation.

 

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IDFC AMC

Sensex EPS

By: Punam Sharma

What is earnings per share (EPS)?
 

  • EPS is amount of earnings per each outstanding share of a company. It indicates how much money a company is making for its shareholders.
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  • EPS indicates company’s profitability.
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  • EPS of a company is calculated as
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  • There are three types of EPS:
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  • Trailing EPS is previous years EPS and is actual EPS reported
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  • Current EPS is present year’s EPS and is based on estimates
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  • Forward EPS is next year’s projected EPS based on estimates
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  • EPS of Sensex is sum of all EPS based on the free float factor of the 30 stocks in the index.
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  • Chart below shows the annual trend of Sensex EPS growth in absolute term and YoY growth from 1991 till 2013.
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EPS of Sensex

 
Growth of Sensex EPS

 

  • From the above two charts, it’s observed EPS of Sensex has grown from 44 in 1991 to 1173 in 2013.
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  • EPS has been growing since 1991 except for 3 times (1997, 1999 and 2009) it’s fallen.
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  • 2013 EPS has been almost flat.
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  • From 1991 to 2013 on average Sensex EPS growth has been around 19%.
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How to value EPS?
 

  • For investment purpose one needs to know at what price to invest in the stock. To know the price, we need to value its earnings.
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  • To value EPS discounted cash flow method (DCF) is applied.
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  • DCF is a method which discounts the future earnings using a discount rate to know what should be the present price.
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  • Discount rate is the rate of return which is required to make it worthwhile to invest.
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  • Discount rate is generally over and above the risk free rate offered i.e. the Gsec rate + risk premium.
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  • In case the current price is more than the discounted future price then it’s said to be overvalued and if the current price is less than the discounted future price it’s said to be undervalued.
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  • Table below shows a DCF done on earnings of Sensex and a Bond having coupon of 7.4% annually to see whether the price was overvalued, undervalued or fairly valued when invested in 2003 using different discount rates.
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earnings of Sensex

 

  • To calculate above DCF for Sensex, actual EPS has been used till 2013 and discounted back using different rates, 8% being the risk free rate.
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  • Higher the discount rate, higher the risk associated.
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  • From above, it’s seen that DCF of Sensex index value is higher than the current index value prevailing in 2003 which means the index was undervalued.
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  • Even assuming the higher discount rate, index is undervalued.
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  • Index being undervalued was a good time to invest.
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  • Similarly, Bond DCF value is higher than the bond price making it attractive to invest.
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Valuing earnings of a bond and stock
 

  • DCF can be applied in Bonds and Stocks1, however there is differentiation between valuing earnings of the two which is shown in the table below.
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Bond & Stock

 
Bond & Stock earnings difference

 

  • From above, we can see that bond earning is fixed each year till it matures.
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  • On bond no growth assumption is required and capital is returned at end of maturity.
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  • Stock earnings keep fluctuating every year and one needs to estimate growth to value the earnings.
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  • To compensate for the risk associated, one expects a return on capital.

 

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IDFC AMC

Sector Weightingsin Sensex

By: Punam Sharma

Sensex Sector Representation
 

  • Sensex is representated by various sectors whose weight is based on free float market capitalization.
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  • Sectors representing the Sensex keeps changing based on the performance of the sector during an economic cycle and accordingly stocks are added and removed changing sector weightings.
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  • Over the years Sensex sector composition has changed and fewer sectors represent the Sensex.
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  • In 1990 around 15 sectors representated the Sensex. Gradually this has reduced and currently only 10 sectors make up the Sensex.
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  • Sensex at any given time is generally dominated by the top 3 sectors which have aggregate of around 50% weight based on free float market capitalization.
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  • Sector composition keeps changing; however there are 8 sectors namely Capital Goods, FMCG, Healthcare, Metal-Metal Products & Mining, Oil & Gas, Transport Equipments, Finance and IT which have been part of the index since 1998 although their weightings have kept changing.
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  • These 8 sectors at any given point have aggregate of more than 80% weightage in the index.
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  • Chart below gives a snapshot composition of Sensex, BSE Midcap and BSE Small cap indices.
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Sensex Composition

 

  • Chart below shows the 8 sector weighting (%) over the years as and when the sector changes were made.
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  • From the above chart, we can observe, Finance sector weighting has been increasing over the years.
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  • FMCG sector’s weighting has fallen over the years while Oil & Gas sector weightings have been in the same range.
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  • We can also see that at any given point of time highest weighting of a sector in the index has been around 20%.
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  • Charts below shows Sector distribution for Sensex, BSE Midcap and Small cap Index.

 
Sensex sector distribution

 
BSE Mid cap & small cap  sector distribution

 

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IDFC AMC

Mean Reversion

By: Punam Sharma

What is mean reversion?
 

  • Mean reversion theory states that a stock return whether high or low will revert back to its mean (average return).
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  • In other words, if a stock return is super normally higher than its mean then eventually it will decline back to its mean. High returns will eventually have a negative trend.
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  • Stock return super normally lower than its mean will result higher return in order to revert back to the mean. Low returns will have a positive trend.
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  • To understand mean reversion process and to know if the return is super normally high or low, a range is determined by calculating standard deviation from its mean.
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  • Standard deviation shows how much the value is dispersed from the mean.
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  • Range can be 1 standard deviation from mean (which is mean ? standard deviation) contains 68% of the data, 2 standard deviation from mean (which is mean ? 2*standard deviation) contains 95% of the data and 3 standard deviation from mean (which is mean ? 3*standard deviation) contains 99% of the data.
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  • Chart below shows histogram of Sensex 1 year daily rolling return from January 2000 till 1 st April 2013 calculating one standard deviation from the mean.
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Histogram of Sensex

 

  • From above chart we can observe that around 68% of the data (returns) have between -16% and 50% which is one standard deviation from the mean of 17%.
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Does Sensex returns show mean reversion?
 

  • To understand if Sensex returns revert back to mean, we have calculated Sensex average daily one year rolling return from January 2000 to April 2013 which is 17% and standard deviation which is 33%.
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  • To calculate the range, one standard deviation from mean is calculated and we get -16% (17%-33%) and 50% (17%+33%).
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  • One standard deviation implies that 68% of times if invested for a year will give returns between -16% and 50%.
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  • Sensex return above 50% or below -16% ranges are said to be super normal returns and will tend to revert back around its mean.
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  • The data shows when Sensex returns have been higher than 50%, it has reverted back by average of 52.3% i.e. fallen by average of 52.3% a year later.
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  • Similarly when returns have fallen below -16%, it has reverted back by average of 49.6% i.e. gone up by an average of 49.6% a year later.
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  • Mean reversion process is shown graphically using Sensex return as an example.
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Mean Revision Process

 

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