Here’s why comparing countries on the basis of PE is ill-advised

February 11, 2008: The Sensex dropped 4.57 percent within a day, as the Index shed 796.43 points. The benchmark Index fell 833 points, or 4.78 percent and closed at 16,630 on growing global worries over slowing economic expansion. The reasons cited for this fall were weak global markets and disappointing corporate earnings.

Shishir AsthanaMoneycontrol Research

Indian markets have had a dream run since the end of December 2016, giving a return of over 16 percent in the span of over four months. This run-up has made Indian markets one of the costliest in the world according to news reports. Reports have compared price to earnings (PE) ratio of various countries to arrive at the conclusion. For the sake of comparison future earnings of 2017 and 2018 have been averaged.

But is PE a good comparison of countries? Just like in a market each sector deserves a different PE, similarly each country based on its economy deserves a different PE.

A commodity company always gets a low PE ratio in the market when compared with a company that adds a lot of value in its manufacturing units. Also, companies within the same sector normally gets different PE ratios on account of governance issues, growth rates, margins and various other operational parameters.

Using the same logic, a company with a higher growth rate has to get a higher PE when compared to a slower one. This has been taken care of in the report by comparing forward PEs based on an analyst estimate of future earnings. A growing economy, like a mid-cap or a small cap company enjoys higher valuation than a developed economy with a lower growth rate which resembles a large corporation.

Here, too, one needs to know that analysts estimate for future earnings is the highest at the start of the year. As the year progresses and numbers start pouring in estimates have historically been revised lower and that too sharply.

In his latest newsletter financial expert and author John Mauldin has pointed out that analyst estimates have always been revised lower in the US from anywhere between 10 and 40 percent over the last six years. Analysts in India have also followed a similar trend. For the last three years analysts have started the year with an earnings growth between 15-20 percent but by the year end the growth has been nearly flat.

Further, countries like Russia, Brazil and South America derive most of their revenues from commodity players. Compared to them in India, commodity players have less than 10 percent of the weightage to the broad indices.

Liquidity is another factor that decides valuation. Higher liquidity means more money is chasing fewer stocks which keep valuations high unless we reach bubble valuations. Same is the case with interest rates. Low interest rates result in investors taking a risk-on approach to investing.

Finally and most important is the government. A stable government ensures a smooth and predictable economy. Markets in such economies see investors enter these markets.

Finally, as Mauldin has shown in his newsletter, it is always better to compare a country’s valuation with its own historic data rather than compare it with other countries. Just because a country is high on the PE list as compared to other countries, it might not be the right way to look at it. Unintentionally, it gives the impression that the country is highly valued.

Based on India’s own historic valuation, we are in the topmost quartile which will restrict growth going forward.