Stock prices always discount future earnings. A company’s stock trades in multiples of its future earnings per share. This multiple which is referred to as the PE ratio is gradually coming down in the Indian stock markets. What we pay for future earnings is coming down. The PE multiple typically ranges between 11 and 22. In times of distress, it hovers at the lower end of the range and when markets get over-optimistic it tests the higher end of the range.
The current sensex multiple (PE) is hovering around 13-14 FY 12 earnings on a forward basis. If we discount FY 13 earnings, the sensex multiple is possibly hovering around 11-12. This suggests that stock prices could be hovering very close to the bottom of the range. What we pay for a stock on a forward basis (let us call this Pay forward) determines our long term returns from equity. Typically, if we are investing at these levels, it is likely that when economic fundamentals improve, we will see earnings expand and PE multiples grow. So, when fundamentals look up we will see PE ratios move from the lower end of the range towards the higher end. As the PE multiples expand, we will see the trend grow into what is called a bull market. A bull market is typically born when the Pay forward (forward multiples) however between 11 and 14. That would mean that we are close to levels which are attractive from the long term basis.
Investors are still sitting on the sidelines. Actually, foreign investors are selling like there is no tomorrow. Their selling is leading to a situation where a sharp fall in valuations in a single trading session is inevitable. On that day, we will see markets hit a PE low and a Pay forward (forward PE) crash. Maybe, 11-12 FPE will be touched on that bad market day. But, knowing investor psychology, on a day when there is a carnage, there will be very few contrarians. The pay forward crash is no doubt a once in a life time opportunity. Investors must keep their cash ready to buy when the markets crash. PE
When the pay forward is low, you will see the payback rise significantly over extended periods of time. When we buy at low pay forward, the markets insulate us against one year of bad or under-par earnings. If the company performance rebounds over the subsequent quarters, the markets will forget the uncertain phase, put it behind and start to discount better earnings. Typically, the Pay forward will increase to 14-15. The twin benefit of better earnings and better Pay forward discounting will create a better than expected payback on our investments.
What should we be doing now? We must use the dropping Pay forward to keep buying stocks of bluechips which have a stable future. Buying the index is also a simple but sensible idea. We must lower our purchase cost to as low as we can. This can be done by buying at every price dip. Buying must have a precise approach to prices. If we manage to buy at low Pay forwards (FPE), we must sit tight on our investments for long spells of time. Typically, it must be for a period of 18 to 24 months. DO NOTHING must be the buzzwords. If we can sit tight, we will see Payback rise significantly as both earnings and Pay forwards(FPE) increase significantly. The wait could extend. But, there is no doubt about the merits of showing patience for more time.