The financial industry and media like to present an appearance of certainty about something that is actually very uncertain. Hence, one often hears glib assessments like "a share is under-valued/ over-valued/ fairly valued at a PE of 25".
A single number is a misleading benchmark. Any common valuation ratio will have a range where it shades from under-valued to fairly-valued to over-valued. Ratios like the price-earnings (PE) ratio, the price book value ratio (PBV), the price-earnings growth (PEG) ratio, and so on, give investors some sense of valuation.
But the relationship is not exact and few investors think about the underlying assumptions while using these ratios. A business doing well will see growth in both denominator (the accounting measure like earnings per share) and the numerator (usually price). The two variables should grow at more or less the same rates when the stock is fairly valued. Hence, the average level of the ratio over the long-term can be used as a rough benchmark of fair valuation.
This is logical enough. Valuation ratios are indeed mean-reverting. Periods of over/under valuation will usually correct back towards the average. But the deviation away from the average may be large and the move away may last a long time. For example, when results are announced, small changes in earnings may trigger much larger changes in prices. Stocks can also remain over-valued or under-valued for years on end.
The sensible investor will identify a range of acceptable valuation rather than focus on a single number. That range itself will not be static. Valuations alter as interest rates change. A lower interest rate justifies a higher PE (the most commonly used ratio) and vice-versa. In a typical Indian cycle for instance, interest rates may swing from between three per cent to above 10 per cent over a three or four year period. Equity valuations cannot remain stable through this.
Similarly, exchange rates matter, even for businesses without forex exposures, since foreign institutional investors (FIIs) are sensitive to currency moves. Changes in fundamentals also affect valuations. So do environmental changes such as shifts in government policy, or technological disruptions.
Valuations may change for an entire economy if there are macro-economic changes.
Experienced investors may not explicitly calculate everything. But they will have a sense of central tendency and volatility of a given stock. A statistically inclined investor may calculate details such as the median, average, standard deviation, and so on. He may map the frequency distribution to judge how closely movements correspond to the normal distribution. Again, approximations and inaccuracies will come to light.
Adjusting valuations in practice for all these changes is a very fuzzy process. In addition, valuation behaviour also varies from industry to industry. More cyclical businesses have wider ranges of valuations.
New industries with high-growth prospects might not see mean-reverting behaviour for years. The IT industry for example, saw many years of high PE ratios because IT was doubling turnover and profits every year. After the bubble collapsed, prices and PE ratios trended south for several years.
We have seen similar behaviour when stocks in the real estate industry started listing in 2007 and 2008. An initial boom was followed by a collapse. In fact, even six years later, one would hesitate to say that the real estate industry has settled down to mean-reverting behaviour.
We mentioned above that exchange rate expectations affect foreign institutional investors. This may be critical at the moment. The last two years India has seen high rupee interest rates, low earnings growth and slow GDP growth. This should, taken together, translate into lower PEs. But the average PE has risen from 19.5 in the past five years, to over 20 in the past three years. This is largely due to FII buying. If FII attitude changes, the stock market could plunge. High currency volatility would be one factor that might lead to FIIs reducing India exposure.
Given all this, while mean reversion is a useful quality, it cannot be applied mechanically. If one is to derive a fair valuation range for the Indian market, it could be the average plus/minus the standard deviation. The market will move outside this range only when there is unusual over/under valuation.
The 2010-2013 PE of the Nifty is 20 and the standard deviation is 2.4. So, going by this rule, an investor should look to increase exposure if the Nifty was below 17.6 (the current PE is 18.2). The three year history suggests that valuations drop below this threshold only about 16-17 per cent of the time. But this could change if there are changes in any of a host of factors.
