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The pitfalls of a valuation strategy

Valuations are easy to quote but hard to understand and interpret. Before you think that this is a sure-shot way to build an investment strategy, consider these points.

Are you one to follow market valuations for your investment decisions? For a long time, the benchmark Nifty 50 at 22-25 x price to earnings multiple (PE), was above its historical average valuation. In simple terms it means that the market is expensive, creating a high probability that it could correct. 

Now that the correction has happened, and the Nifty 50 is below its long-term average valuation at 17-18 times PE. Is it a good time to be an aggressive equity investor? 

Valuations are easy to quote but hard to understand and interpret. Before you think that this is a sure-shot way to build an investment strategy, consider these points. 

1. Valuations can remain irrational for long

PE multiple measures the price you are willing to pay per rupee of earning or net profit that a company makes. In general, if the PE multiple of a stock is 20 times, you expect its annual earnings to grow more or less at a rate of 20%. If that doesn’t happen for a prolonged period, then it is considered overvalued and the stock price ideally can fall and vice-versa. 

At an individual level and on a market index level, valuations can remain out of sync with the actual earnings growth of a company or a portfolio of companies for a long time. In the current cycle, the valuations have been expensive for over a year. Should you then have remained out of equity as an asset since the start of 2019? 

Invest with a rational asset allocation and invest regularly so that you accumulate at every point in the market cycle. The valuation can remain inaccurate for a long time without any apparent reason and as we saw corrections can be sharp and sudden.  While you may not want to be around when it's expensive, you will want to capture the lows after markets correct and for that remaining invested is important. 

At an individual level and on a market index level, valuations can remain out of sync with the actual earnings growth of a company or a portfolio of companies for a long time. In the current cycle, the valuations have been expensive for over a year. Should you then have remained out of equity as an asset since the start of 2019? 

2. Not as simple as the calculation

Calculating PE is simple. But there are many other factors that determine the final number which represents the valuation accurately. Gauging this accurate number for each stock or a portfolio or an index is not as simple as the calculation.

Some stocks trade at premium valuations for decades; premium valuation reflects the willingness of investors to consistently buy shares at a price above their accurate value. This might happen because of intangibles like brand value or innovation. The opposite is also true, the valuation of a stock can be lower than its actual earnings growth because of some relevant reason like high debt or it could just be perception.

It’s very hard to distinguish accuracy of valuation at an individual stock level unless you work as a stock analyst. This can be true at a market index level too. Again, it’s better to focus on your asset allocation and regular investment, rather than trying to decipher the nuances of valuations. 

Earnings uncertainty is high in this new financial year. This means it’s hard to extrapolate how earnings will grow, and hence, a below-average market PE is not reliable and may not be an accurate indicator to aggressively enhance your asset allocation in favour of equity. Equity stocks and funds come with periods of price volatility which we have to bide through to reach the end long term return objective. 

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