How to Use Sensex PE Ratio to Master the Stock Market – A Guide to Sensex PE

How to Use Sensex PE Ratio to Master the Stock Market A Guide to Sensex PE

Sensex PE Ratio is the holy grail for investors worldwide. It helps them decide whether the market is undervalued, overvalued or fairly priced. After all, that’s the secret of making money in the market, isn’t it?

You buy when others are greedy and sell when they are fearful. So, let me ask you…’What did you do on 3rd April 2020’? Were you fearful or greedy? What’s so special about this day? Well, the Sensex hit a low of 27,590. It’s PE fell from 24.60 to 18.80 in one month! Investors rushed to their trading terminal to sell their stocks in panic.

It was as if the markets wouldn’t open the next day. Then came 16th February 2021. What did you do on this day? Sensex hit a lifetime high of 52,462. Investors pumped money into the markets as if there is no tomorrow. Sensex PE was at a lifetime high of 35.10. Sensex PE is still trading 54% higher than its average PE over the last 24 years. Are you fearful or greedy? What is the ideal PE ratio of Sensex? Is Sensex overvalued? Should you sell your portfolio and wait for a fall? These are some of the questions that we will answer today by studying the Sensex PE ratio of the last 24 years.

In this article:

What is Price to Earnings Ratio?

Price to earnings ratio shows how much investors are willing to pay for a share in a company’s earnings. For example: The PE ratio of Asian Paints is 89.20. Its current market price is Rs 2,774. Its earnings per share (EPS) is Rs 28.67. This means investors are willing to pay 89 times to earn one rupee of Asian Paints earnings. PE ratio is calculated by dividing a company’s stock price by its EPS. It helps us decide if the price paid for a stock is equal to the value it generates. Wait… Does this mean price and value are not the same thing?

Watch this video to learn everything about PE ratio

What is the Difference Between Price and Value?

To understand PE ratio, you first need to understand the difference between price and value. Let me explain. Will you buy a dairy milk chocolate from me at Rs 500? Of course, not! No one will pay Rs 500 for a chocolate worth Rs 10. What if I reduce the price to Re 1? Will you buy it now? Yes, you will. Why did you change your decision? Simply because at Rs 500, the price far exceeded the value you will derive from the chocolate. Investors face the same dilemma while investing in stocks. The current market price of Tata Consultancy Ltd is Rs 3,000. Will you buy the share if a seller asks for Rs 4,000 per share? Absolutely not. What if someone is ready to sell the stock at Rs 2,000? You will immediately buy it, right? In the same way, Sensex is at 48,700 on 14th May 2021. Will you buy it? Is this valuation fair or overpriced? This can be answered using the PE ratio of Sensex.

What is Sensex PE Ratio?

Sensex is the benchmark index of the Bombay Stock Exchange (BSE). It contains 30 of the biggest and most traded stocks in India. These 30 stocks belong to sectors like Financial Services, Information and Technology (IT), Banks etc. By capturing the movement of these 30 stocks, Sensex captures the pulse of the economy.

[Read More: 30 Sensex Stocks and their Weightage] Sensex PE ratio is the amount investors are willing to pay for one rupee of earnings in 30 Sensex companies. PE ratio of Sensex in May 2021 is 31.10. This means investors are willing to pay 31 times to earn one rupee.

  • A low Sensex PE denotes an undervalued or cheap market. It’s a strong BUY signal for investors.
  • A high Sensex PE means the market is overvalued or expensive. It’s a strong SELL signal for investors.

How to Calculate Sensex PE Ratio?

To calculate Sensex PE ratio, you will need the following:

  • Current market price of Sensex
  • Earnings per share of Sensex

Current market price of Sensex is easily available. The current market price of Sensex on 14th May 2021 is 48,592.  The formula to find the EPS of all 30 Sensex stocks is: EPS of Sensex = (Net profit of the company / number of outstanding shares) * weightage in the index. For example: The EPS of HDFC Bank Ltd on March 2021 is Rs 57.70. Its weightage in Sensex is 11.84%. So, its contribution to Sensex EPS will be 6.83. Similarly, you do this for all 30 stocks to calculate the EPS of Sensex. Then you simply need to divide Sensex’s current price by EPS and you will get the PE ratio of Sensex. Once you calculate the PE ratio of Sensex, the next question is … What is the Ideal Sensex PE ratio? To know this, let us first have a look at the historical PE ratio of Sensex since 1999.

Sensex PE Ratio From 1998 to 2021

 What do you see in the above chart? Notice how every time Sensex PE exceeds the 20 mark, the market falls. We have seen this in multiple occasions:

  • The PE ratio of Sensex grew by 86% between 1998 and 2001. In 2002, Sensex PE fell to 16.55. A fall of 30.72% in just 12 months.
  • The PE ratio of Sensex grew by 33% between 2005 and 2008. In 2008, it fell by 30.74%!
  • In March 2020, the PE ratio of Sensex fell from 24.60 to 19.60. A 20% fall in just one month.

But there is a silver lining. Every time there is a fall, markets have recovered in 12-15 months. We saw this happen in 2009 and 2020.

  • Sensex PE ratio fell by 30.74% in 2008. In the very next year, Sensex PE was up by 28.54%.
  • In April 2020, Sensex PE was 18.8. In April 2021, it was 33.50. Sensex PE recovered more than 78% in just 12 months!

The below table shows monthly Sensex PE ratio between 1998 to 2021.  As you can see, markets are highly overvalued right now. This brings us to an important topic… What is the Ideal Sensex PE ratio?

Ideal Sensex PE Ratio

The (average) Sensex PE ratio is 20.22. A Sensex PE ratio in 12-15 range is an excellent buying opportunity. But it is extremely rare. In the last 24 years, Sensex PE ratio was in 12-15 range only twice … in 1998 and 2003. Whereas it has been in the fairly priced range of 15-20, 50% of the times in the last 24 years. So, Sensex PE ratio between 15-20 is a good (realistic) entry point for investors. The below table will help you identify whether the market is overvalued or undervalued.

Sensex PEValuationsWhat Should Investors Do
Greater than 25Very Expensive (Overvalued)Be Fearful. Investors can book profits while traders can short sell.
20 – 25ExpensiveInvestors can book partial profits.
15-20Fairly PricedInvestors can hold their investments
12-15Undervalued MarketBe Greedy. Investors can invest in fundamentally strong stocks.
Less than 12CheapAn extremely rare event. A great buying opportunity

Current PE ratio of Sensex is 31.10. It reached a lifetime high of 35.10 in February 2021. This year has already seen a correction of 11% in Sensex PE. Is this the start of a massive correction? Yes and No. Sensex PE ratio can be easily manipulated. Excess cash or debt in the balance sheet increases PE ratio. Sometimes, one stock can lift or drag the entire PE ratio. For example: software and consumer goods companies like TCS, Infosys, Hindustan Unilever etc. trade at very high PE ratios. Whereas oil companies like ONGC have a low PE ratio. A higher weightage to software companies can easily manipulate Sensex PE ratio. This is why you should consider two more factors to decide if the markets are really undervalued or overvalued.

The Trinity of Market Valuations

  • Sensex PE Ratio
  • Sensex Price to Book Value (PB) Ratio
  • Sensex Dividend Yield

What is Sensex Price to Book Value?

PB is a company’s share price to the book value of its assets. It tells investors how much proportion of assets they own by buying a stock. A high PB ratio means investors are paying a higher price for the company’s assets. Here is the Price to Book Value of Sensex since 1998. The average price to book value of Sensex is 3.25.

  • A Sensex PB ratio of more than 4.5 means the market is overvalued.
  • A Sensex PB ratio between 2.75 to 3.25 means the market is fairly priced.
  • A Sensex PB ratio below 3 means the market is undervalued.

Before the 2008 crash, the PB of Sensex was 5.47. That’s almost twice the ideal Sensex PB ratio. The current PB ratio of Sensex is 3.25 which signals a fairly priced market.

What is Sensex Dividend Yield?

Dividend is a way for companies to distribute profits. Dividend yield is the ratio of dividend paid to a company’s share price.  The average dividend yield of Sensex is 1.42. It was 1.04 just before the stock market crash of 2008…signalling an overvalued market. The current dividend yield of Sensex is 0.80. Another thing to consider while analysing Sensex PE ratio is Earnings Growth.  You should ensure that a high PE is supported by high earnings growth. If Sensex PE rises without an increase in actual profit of 30 companies, then this is a big red flag for investors. The PE ratio of Reliance Industries grew by 111% (absolute terms) between 2016 and 2020. During the same period its net profit margins fell by 38%! The stock occupies the highest weightage in Sensex. So, you are paying higher price for lower earnings. So, the question is: ‘Are investors paying higher PE for lower earnings?’ If yes, Why?  This is one of the reasons why Reliance Industries is a 0.5-star rated stock as per Samco’s Star Ratings!

Analysis of Sensex PE Ratio for 2020-21.

 Doesn’t this look like a roller-coaster ride? This is in fact the monthly PE ratio of Sensex since January 2020. This was shortly before the lockdown. In March 2020, Sensex PE was at 19.6. This is extremely close to its long-term average PE of 20.22. This was a big buying opportunity for investors. If you invested Rs 1 Lakh in Sensex in April at 27,590, its value today would be Rs 1.76 Lakhs. That’s a gain of 77%! Stock market has time and again presented such opportunities to investors. But investors have failed to make any money. There are many reasons for this failure – lack of knowledge, time, trading ideas, poor risk management etc. Common retail investors have always remained in the backseat. While Rakesh Jhunjhunwala, Radhakishan Damani etc. made their riches from the market. But it’s about time we change this. In fact, Samco has gotten the ball rolling. Samco’s KyaTrade is a unique trading platform which generates money making ideas every hour! These ideas come with in-built risk management (stop loss and target). KyaTrade aims to maximise your wealth using a 2:1 risk-reward strategy with 50% accuracy. Learn everything about KyaTrade by watching the below video. So, stop wasting your time in fake ideas and instead choose KyaTrade…Instant Trading Ideas, a Swipe Away. Download the KyaTrade app for FREE now!

FAQs on Sensex PE Ratio

  1. What is the ideal Sensex PE Ratio?

The average sensex PE ratio over the last 24 years is 20.22. Sensex PE ratio below 15 means the market is highly undervalued or cheap. Sensex PE ratio greater than 25 means the market is very expensive.

  1. Is Sensex Overvalued?

As of May 2021, the PE of Sensex is 31.10. This is 54% higher than the average PE of 20.22. This does signal an overvalued or expensive market.

  1. What is the Price to Book Value of Sensex?

The average price to book value of Sensex is 3.25. The current ratio is 3.24. A PB ratio of more than 4.5 signals an expensive market.

  1. What is the Dividend Yield ratio of Sensex?

Dividend yield ratio helps investors understand the market’s valuation. A dividend yield ratio of 1 or less than 1 means the market is overvalued. The 24-year average current dividend yield ratio of Sensex is 1.42. The current dividend yield of Sensex is 0.80.

  1. What was the PE ratio of Sensex during the 2008 market fall?

The PE ratio of Sensex in 2008 fell to 15.66 from 22.61 in 2007. This was a 30.74% fall in one year!

Download App to know your Andekha Sach

Get the link to download the app.

Google Play Store App Store
Samco Fast Trading App

About The Author

Leave A Comment?