The broader market indices have fallen in the recent past, but the commonly used valuation ratios, such as the price-to-earnings ratio (PE), didn’t mirror this fall. This is because earnings per share (EPS), the denominator in this ratio, also came down during this period, thus not allowing any fall in the share prices to be reflected in the PE ratio. This is why experts suggest that investors should look at alternative ratios such as the Shiller PE ratio.
The Shiller PE ratio has been developed by Robert Shiller, winner of the Nobel prize for Economics in 2013. The main advantage of the Shiller PE ratio is that it eliminates the fluctuations in the regular PE ratio caused by variations in profit margins during business cycles. The regular PE uses the trailing 12 months earnings per share (EPS). Since companies usually report high margins and earnings during upcycles, the regular PE will be low during cyclical peaks, sending out buy signals. Similarly, during margins and earnings crash during cyclical bottoms, the regular PE will be high, and give out sell signals. For example, the share price of Cairn India almost halved in the recent past, but its PE doubled because of the fall in EPS. You can also see a similar situation with stocks of public sector banks such as PNB.
There is another reason why we should use seasonally adjusted PE for cyclical sectors. “Last year, some cyclical companies reported losses, so the normal PE will not work (PE will be negative),” says Rajesh Agarwal, Head of Research, AUM Capital. Shiller PE, on the other hand, is calculated based on the EPS of the last 10 years. To make historical EPS values comparable to the current share price, the same is adjusted for inflation. Since this includes periods with high margins and low margins, the average EPS is cyclically adjusted. This is why Shiller PE is also known as CAPE ratio (cyclically adjusted PE ratio) or PE 10, because its based on 10-year data.
How is the Shiller PE placed now with regard to Sensex valuation? While the broader market, on trailing PE basis, is still in a reasonably valued zone, it is in an undervalued zone going by Shiller PE. The Sensex’s trailing 12 months PE is placed at 18.47, just below its 10-year average of 19.26 and, therefore, can be considered to be in a reasonably valued zone. On the other hand, its latest Shiller PE is placed at 16.40, significantly lower than its 10-year average of 24.03. The Shiller PE is also closer to its historical bottom. While trailing PE is 78% above its bottom, Shiller PE is just 28% above.
Though Shiller PE generates better results while analysing the cyclical companies, investors should not treat it is as absolutely foolproof. Just like the regular PE, Shiller PE should also be seen in relation to a company’s earnings record. “Earnings trajectory is very important. The counter may look cheap on PE, but will go down further if the earning keeps on falling,” warns Hemant Kanawala, Head of Equity, Kotak Mahindra Old Mutual Life Insurance. Also, investors must remember that when using a new tool such as the Shiller PE, consistency in its application, across market cycles, is a must. “If investors are using Shiller PE in a bear market, they should use it in the bull market as well,” says Kanawala.
