Sensex and Nifty are the two indices which represents are movement of the entire market. Today the two indices have hit the all time high of 30,248 and 9,407 respectively. Now the question arises “whether the market is overvalued”? Before we answer to this question lets discuss on “How to value the investment tool?” There are various methods to value but the most important valuation measure is P/E Ratio (Price to Earnings Ratio). P/E Ratio in simple terms means how much extra you pay to earn Re. 1.
For Example, let’s take the share price of SBI as Rs.295 (as on 10 May 2017), everyone knows the market price of this stock but not everyone knows its actual value. The market price of any share is determined by multiplying Earning per Share (EPS) with Price to Earnings Ratio (P/E Ratio). Earnings per Share are total earnings made by the company divided by no. of shares outstanding whereas P/E ratio is current market price of the share divided by earnings per share. Market price of SBI is 11.2(tailing 12 months EPS) X 26.3(P/E Ratio) = 295.
From the above example of SBI, tailing EPS is Rs. 11.2 that means P/E ratio (295/11.2) is 26.3 times that means an investor is paying 26.3 times extra to earn Rs. 11.20, this is how to get the value of an investment.
The same goes with the valuation of Sensex, presently the EPS of Sensex (the combined EPS of all the 30 companies which forms the Sensex index) is Rs. 1324.48 so by this we get the P/E Ratio of Sensex as 22.60X. If we look at the P/E ratio of Sensex which is 22.6 X it seems to be overvalued because the long term average P/E ratio is 19.25X. But as past analysis shows that during 2007 the Sensex P/E has even gone up to 29X and also in 2000 it has gone up to 30X and also in 1992 and 1994 it has also gone up to 50X. Therefore, it clearly shows that no one can say when the markets will correct itself.
Conclusion – We find the markets to be overvalued at this range we recommend the value investors to not infuse new money into the equity market but should reduce the equity allocation and increase the allocation to debt markets and wait for the next market correct in order to buy equities at undervalued prices.