There’s this Yellow Coloured Broking House,that’s been screaming Yellow ! for some time Now…Last Week they used Slumdog Millionaire Analogy and Two days ago they have slammed Valuation Metrics of P/E and P/BV to value our Stock Markets !…This House continues to court controversies and it’s head SS continues to confront SEBI !…. Atleast I have to concede that his reports are entertaining…I asume they are his,as they are written in first person ,but no credits have been given !…one need not agree….but even to disagree,you need to know what he’s playing the Devils Advovate about !
They’re rough on Living Investment Legend and Value Investor,Warren Buffett and expect the S & P 500 to correct yet further to 450 from current 650-700 levels !…In short they continue to spew stark yellow,yellow,dirty fellow Bearisms all over their Yellow Reports
They are entitled to their Views….I’m not saying I’m Bullish ,but I can’t help but strongly disagree with their ‘analytical and conceptual rigors’,as they put it!
They thrash P/E and P/BV,asserting strongly that it is foolish to compare these metrics between different years….as skewness in individual constitutents earnings,ROE,COC,Inflation etc influence performance…and factors for skewness and replacing constitutents in the Index are not considered….Relative Valuations Comparisons over Different Periods are therefore not Apple to Apple,and to make them so,is really an improbable task.
Darlings,Comparisons do tell a story…all your arguments are already build into the Pricing,sometimes laggardly as Eugene Fama’s Hypothesis of Strong,Semi-Strong and Weak Markets would decide …moreover Suitability and Selection of Constituents is an ongoing process so that these represent best proxies and the best mix and therefore ,with a few exceptions,the aggregate EPS can be used as a denominator to Index level and this Multiple can be compared between periods to make macro valuation calls…This should answer your argument on skewness of Earnings and the hypothetical illustration you give where in three Seperate scenarios the P/E wll be 10 as Market Cap of all constituents is 500 and aggregate earnings is 50….but the skewness in earnings of the individual constituents varies from stable to extreme.
You have tried to obfuscate,what really is a simple comparative issue,by putting up a P/E Formula…use Graham & Dodd (1934)or even the perfected Gordon’s (1962) model to incorporate Growth…..Simply P/E =Market Price /EPS….so when Market Price begins to runaway ahead of fundamentals,the P/E too goes berserk…..Check out History…In 1992,at the peak of Harshad Mehta’s reign and his frenzied Market Buying ( Remember ACC crossing Rs 10000 and Crackers on Dalal Street ! based on Harshad Mehta expounding the Replacement Cost Theory !)the Sensex P/E was an absurd 70….Even in the mid 1990s, when CCI was abolished and IPOs were like white ants coming out of the woodwork at obscene premiums,the Sensex P/E was 30+…Then in Ketan Parekh’s ICE age in 1999/2000,the Sensex P/E again crossed 30 as Panic Buying set in and Prices tried to reach the Moon !….These were times of excess and Markets were clearly overvalued…In 2001-2003 the P/E slumped to below 10 as Share Prices seemed to revolt against man made excesses !…clearly moving markets back towards sanity
Then we had the Real Estate Booming as DCR 2001 came into force and once we adjusted BVs of Companies holding Land that could be redeveloped or sold we found compelling buys on the low P/BV Metric
As P/E falls and EPS appears sustainable,Investor paybacks periods shorten in length,attracting Buyers
Ofcourse P/E and P/BV should not be looked at in isolation…and we’re not !…I’ve personally made successful contrarion calls in 1992,mid 1990s and 2001 partially based on these Metrics…am on record for this…in fact in 2001,held a Workshop at the World Trade Centre in Mumbai on Repairing,Revitalising and Repairing your Equity Portfolio
So don’t preach that P/E and P/BV Metrics cannot and should not be used to make macro Valuation Calls !
They Can…..Ofcourse the difficulty in calling a Bottom or a Top remains…but you do get a sense of perspectives in terms of Period P/Es and P/BVs