Market overvalued? Consider Shiller's cyclically adjusted PE, not regular PE, to find out

A black swan event breeds exceptional outcomes. But, when you analyse a trend, exceptions do not make for accurate conclusions. Coronavirus-induced economic slowdown is a big aberration of financial year 2020-21. Although the economy was already on a downturn before the virus gripped the country, the expected blip in corporate earnings and gross domestic product in FY21 (and the rebound in FY22) can only be studied in silos. In that case, how will the most popular valuation metric PE ratio -- that relies on 12-month trailing and forward earnings per share -- depict correct market valuations? It cannot. This is why a lesser known valuation metric Cyclically Adjusted PE Ratio (CAPE) that takes into account average earnings of last five to 10 years is what analysts are recommending to value stocks in the current scenario. Introduced by Nobel laureate Robert Shiller, CAPE is also called Shiller PE ratio.

"COVID-19 outbreak has induced a temporary demand and supply shock, which makes it highly uncertain to forecast FY21 NIFTY50 earnings (downgraded 24 per cent so far). Also, going by consensus forecasts, India's economy and NIFTY50 earnings could rebound in FY22 which implies FY21 estimates are not sustainable," says a report by brokerage ICICI Securities, adding that FY21 consensus earnings do not provide confidence of accuracy and hence, lose analytical relevance in valuing stocks.

That said, analysing Schiller PE ratio could be the best approach in the existing scenario. "Even without COVID-19 impact, using single year EPS forecast for valuation is erroneous," says ICICI Securities.  Not only does Shiller PE eliminate business cycle aberrations, but also accrual accounting ones. "Using earnings at the peak or bottom of a business cycle will induce serious investment mistakes as cycles revert to the mean. For example, the ex-ante forward P/E at the peak of the global financial crisis did not seem alarming at ~20x but CAPE was sharply high at 34x indicating the error of extrapolating peak cycle earnings."

Similarly, if a company makes major or inadequate accrual accounting in a particular year, it may reverse in later years with one-off gains or losses in EPS, thus rendering one-year EPS study erroneous. For example, ICICI Securities says that in the current context of COVID-19, different levels of provisioning by various lenders will impact their current and future earnings. Thus, one-year EPS-based valuation for lenders will not hold true, but average EPS of several years that reflects in Shiller ratio can help.

However, there is one element that may render Shiller ratio erroneous, that is, change in tax rules. Deepak Jasani- Head of Retail Research at HDFC Securities says the CAPE ratio can be potentially skewed if tax or accounting rules change enough over time. To avoid this aberration, you need to study CAPE in shorter cycles against long-term average. "Using shorter cycle of five years and limiting the cape history to 15-20 years can resolve the issue of using data from a different era of taxation and accounting rules," says Vinod Karki, Head - Strategy, ICICI Securities.  

What do existing ratios display?

As per ICICI Securities, CAPE based on 'average real earnings' of the past five years for Nifty50 is ruling at 20x, which indicates marginally below average valuations for the market. According to Siblis Research, the 20-year historical average for Shiller ratio is 22.71. It had gone as high as 27.49 by December 31, 2019.

The one-year forward P/E for Nifty50 is ruling at 18.5-19x, versus the long-term average of 17.4x, according to HDFC Securities. The higher the value above the long-term average, the more overpriced the index becomes. The existing ratio, says Jasani, displays valuation as of normal times, that is, either buy or hold.

At Tuesday's close, the Nifty50 one-year trailing PE stood at 26.05x, 51.45 per cent higher than 17.2x quoted on March 23, the lowest since May 2014. It had reached as high as 28.67 as of January 14, 2020 when the index had hit its all-time high of 12,362.30. A range between 25-30x is considered highly overvalued. So far as market-cap to GDP ratio (also known as Warren Buffett indicator) is concerned, Jasani says it is in the range of 64-69 -- as it has been in normal times. "In bull times it rises to 71-83 per cent."

Thus, while forward PE and market-cap to GDP ratios depict normal times, trailing PE is clearly overvalued. It is only CAPE that shows below average valuation. One would do well to avoid normal to over-valued forward and trailing PEs to assess market valuation as it may not be giving correct picture due to COVID-led aberration in earnings. "Ultimately, whether we are in normal times or stressed times is a call each one will have to make. This will decide whether we are fairly valued or overvalued," says Jasani.

Should you invest?

Timing the market is a tough nut to crack. Most analysts believe there is never a wrong time to enter into markets, but crux lies in the amount that you invest as per what is available to you. "It is difficult to time markets and serious investors should focus attention on business fundamentals of each company and if valuation frameworks such as CAPE or even simple P/E ratios provide signals of reasonable valuations, they should buy. But it is not wise to deploy 100 per cent," Karki of ICICI Securities says .

Consider taking a staggered approach to invest in the current scenario. So far as individual stocks are concerned, according to ICICI Securities, ITC, HDFC Bank, Eicher Motors, NTPC, Sun Pharma and L&T on Nifty50 are attractive picks going by their 'five-year real earnings' Shiller PEs.

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