Nifty 50 looks attractive overnight? Don’t fuss; it’s a mathematical change

From April this year, index enthusiasts were in for a surprise. Overnight, the Nifty 50’s Price-Earnings (PE) ratio fell from 40 to 33. And that was without any change in market levels. There was no market crash or anything:

What exactly happened to cause such a fall? NSE decided to change the methodology of calculating Nifty PE.

Standalone versus consolidated earnings

Earlier, the PE was calculated based on standalone earnings (of trailing four quarters) of the 50 companies that make up the index. But from April this year, NSE switched to using consolidated earnings instead of standalone profits.

Since consolidated earnings are generally higher than standalone ones (at least for a large group of companies), it increased the value of the denominator in the P/E ratio, i.e., the value of E increased. And since P (index value) remained constant, the P-by-E ratio fell mathematically from 40 to low 30s, overnight.

Many investors use Nifty PE as a shortcut to assess whether markets are overvalued, fairly valued or undervalued. A low P/E Ratio typically indicates undervaluation. So, does a fall from 40 to 33 (as of end-May, it is at 29-30) mean that Indian markets have suddenly become undervalued and attractive? The answer is no.

Let me offer a simple analogy. Suppose a car is going at 161 km/hr. Now, if I say that car is going at 100 mph, does it mean the car has slowed down? No. I have just changed the measure of distance from kilometres to miles. Since 100 mph is equal to 161 kmph, the car is still going as fast as it earlier was.

The same is the case with Nifty PE. A fall of PE from 40 (on a standalone basis) to 33 (on a consolidated basis) doesn’t exactly mean that markets have become cheaper. The PE generally falls when markets correct suddenly. But in this case, it was just a change of methodology that corrected the PE.

So it is actually wrong to say that Nifty valuation has become cheaper. Had NSE used consolidated figures to calculate PE earlier, then it would have been reporting lower PEs even then.

But what was the sudden need to shift to consolidated earnings from the earlier approach of using standalone numbers?

The shift in methodologies

In the earlier days, Indian companies weren’t as large as they are now. Also, their subsidiaries were either very small or still finding their feet (were unprofitable with negative earnings). So, the consolidated earnings of the companies were more or less the same as their standalone earnings (as subsidiaries didn’t contribute much to the bottom line). But over the last decade or so, many subsidiaries have grown by leaps and bounds. And these subsidiaries now make reasonably large contributions to their parent company’s performance.

Let’s take an example. Suppose in year 2005, a company’s share price (P) was Rs 1000, while the earning-per-share (E) is Rs 100. The company had a small subsidiary but on a per-share-basis, its earning was just Rs 1. So, if we calculated the standalone PE ratio, we get 1000/100 = P/E of 10.0. If we considered subsidiary and calculated consolidated PE, then we would get 1000/101 = PE of 9.91. As you see, there is not much difference between standalone and consolidated PE, which are 10 and 9.9, respectively.

Now in 2021, the subsidiary has grown much faster than the parent company. The share price is, say, Rs 10,000. Earning-per-share of the parent is Rs 1000 and that of the subsidiary is Rs 500. If we calculate the standalone PE, we get 10,000/1000 = P/E of 10. But if we calculate the consolidated PE, we get 10,000/1500 = PE of 6.67. Due to the higher contribution of subsidiaries, now the consolidated and standalone earnings are very different. And so is the PE calculated for both types of earnings.

So when Nifty’s PE fell from 40 to 33, it was because the total earnings of the NIFTY 50 companies had increased with the use of consolidated earnings, which led to an increase in the denominator of P/E Ratio calculation formula. And as a result, the PE ratio fell.

One should not make the mistake of thinking that earnings have actually improved here. It’s just that consolidated numbers are now being used instead of standalone ones. Nothing changes on the ground.

Direct equity investors using the Nifty PE in their strategies, will now have to rework theirs and compare consolidated data of past years as well. But having said that, PE should not be the only factor to consider when deciding to invest or sell. It needs contextual interpretation along with an assessment of other factors as well. Like where is the index on the earnings cycle front, or for a given PE level X, is it coming off from a period of high or low earnings, etc.? As for the SIP investors in mutual funds (both active and passive), there is nothing to change as long as they invest the right amount regularly, and rebalance in line with their goal timelines and risk profiles.