With the market shooting up vertically to all-time highs, is it time to be fearful that a top has been made? Not, by a very important valuation metric
The S&P BSE Sensex and the NSE CNX Nifty are currently trading at their all-time highs. The Sensex has breached the psychological 27,000-mark and the Nifty has breached the 8,000-mark. Valuations too, have shot up compared to the past few months. With the market hitting newer highs and valuations inching higher, investors fear whether the market is entering a bubble zone. Are these fears validated or just plain ‘bubble’ talk?
Over the past year, the Nifty has gained 46.19% as on 3 September 2014. While all major global indices have been trading in the black over the past year, this is the highest return over the year compared to other global indices. The US Nasdaq which gained 31.09% and the Indonesian IDX Composite which gained 28.25% were the next best performing global indices after the Nifty and the Sensex. This would make one wonder, whether the price-level of the Nifty and Sensex has reached a peak.
In terms of valuation, the price-to-earnings (PE) of the Nifty has grown by 32.63% to 21.22 times from 16 times over the same period. That means earnings have contributed approximately 14% to this growth. The long-term average of the Nifty PE works out to 18 times. However, the PE of 21.22 times is still 18% below its peak of 25.19 times seen in October 2010 and 24% lower than the peak of 28.29 times seen at the beginning of January 2008. The PE data is as reported by NSE, based on the 12-month trailing earnings. The problem is that past earnings are not always very a reliable guide to market valuation.
Moneylife looked another valuation metric, the price-to-sales ratio (PSR). PSR was first used and popularise by KenFisher in 1984 in a book called Super Stocks which became a huge best-seller. To get the PSR, you have to divide a stock’s market-cap by its total sales. This would help you identify stocks that are selling cheap relative to sales.
The importance of PSR as a measure of value cannot be overestimated. The most popular measure of value is price/earnings ratio or P/E. Fisher argued that there were major drawbacks to an earnings-based valuation measure because earnings, even of good companies, can fluctuate hugely from year to year. Replacing equipment or facilities, extraordinary income and losses, or write-offs on research and accounting, deeply influence reported earnings. To Fisher, the drawback of P/E was obvious. Also, while profits can be manipulated easily (because it is a small and residual figure), it is hard to cheat on the reported sales figure in a major way. As Fisher puts it, “Price Sales Ratios are the most powerful single valuation method which I am familiar with. They are not well known, less well understood, and seldom used within Wall Street. They work much, much better than price-earnings ratios.”
So where is the Sensex as per PSR? We calculated the quarterly PSR of the Sensex over the past 15 years. According to this metric, the Sensex is currently quoting a PSR of 2.88 times. At the peak period, in December 2007, the PSR was 4.29 times. As the market crashed, the PSR fell to a low of 1.99 times in March 2009 and then it went on to hit a peak of 3.09 times in September 2010. So, even as Sensex is 4,000 points above the level of November 2010, PSR is lower today.
In December 2011, the PSR fell to 2.06 times when the Sensex then had fallen to around 15,500. Since then the PSR has not moved much until March this year. From March 2014 to now, the PSR has increased from 2.22 times to 2.88 times as on 1 September 2014.
Considering the average PSR, which works out to 2.19 times, the current PSR is approximately 31% higher, but still below the previous bubble high. Nothing in the market, of course, is hard and fast but at a PSR of 2.88, Sensex is not cheap but it is not horribly expensive either.