Index P/E Ratio and its importance

Here we are looking at the index P/E ratio and its possible use while making investment decisions. I have taken the data from Indian index (Sensex), we should be able to do similar analysis for any of the indexes.

Following chart is based on P/E ratio of Sensex from Jan 1995 to Jun 2009. Index values as such cannot be used to compare with historic data, but since P/E is a ratio, we can compare P/E with historic P/E data.



Few things to notice:
- The P/E ratio has a normal range which seems to be between 15-25.
- Every time the ratio crossed above 25, it was short and lead to a sharp fall in market.
- Every time the ratio crossed below 15, it was poised for a rise.
- Earnings ('E' in P/E), because it can be manipulated is not considered to be a very reliable number for analysis which makes P/E ratio not the best ratio to use. But when taken on a collective basis like in Index, it may offer a better indicator.
- When P/E is above 25, it does not matter if you are holding an undervalued, growth or any other type of stock, all stocks were hit sharply. Best thing at this point may be to consider selling.
- Individual company analysis is important, but factoring in the market condition based on this historic data may help.
- This indicator may be worth looking into especially when the current ratio is outside the normal range.
- Over a long duration of time, there may be changes in the what we consider 'normal range'.
- Index can go up without affecting the P/E, if there is a corresponding increase in the earnings.

- Notice that currently market P/E is around (as of Jul/15/2009): 18.52.

I will be publishing the current P/E data periodically on the site (right side) in 'Indexo Meter' graph.