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.
- Suppose P/E is 20, it means that one is willing to pay 20 for a 1 earning.
- P/E is calculated as

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.
- 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.
- Average P/E of Sensex is 15*.
- 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.

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

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

Source: Bloomberg

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

**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.
- Price/Earnings to Growth (PEG) ratio tell how the markets are valued on P/E and earnings growth. It’s calculated as below

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.
- PEG greater than 1 means market is overvalued as P/E is highly priced compared to its EPS growth.
- PEG less than 1 means market is undervalued as P/E is cheaply priced compared to its EPS growth.
- 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%.

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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