Equity Market & PB Ratio

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PB Ratio and Equity market valuation

Equity Market has seen a good rally after correction in March, 2020 due to Covid. The biggest question running in the mind of investors right now is whether equity exposure should be reduced. In this article, we try to figure out the answer to this question by using the indicator PB Ratio.

Price to Book (PB) Ratio helps in understanding how many times the stock is trading over and above the company’s book value. The PB Ratio is calculated by dividing the current market price of stock with book value per share of the company.

PB Ratio is a good indicator for valuation of a company or the broad equity market. If PB Ratio is trading at a value higher than long term average of the ratio then asset is overvalued. Similarly, a value below long term average is a sign of undervaluation.

In the current Covid times, the valuation indicator PB Ratio has become more meaningful especially because PE (Price to Earnings) Ratio has become irrelevant. The corporate earnings have fallen because of Covid and lockdown. This correction in earnings is short term and not structural. The earnings will again bounce back after 2-3 quarters. Since earnings have fallen, the PE Ratio has automatically gone up and is giving a false indication of overvaluation. Its better not to use PE Ratio till the time earnings normalize.

Here, we have tried to analyse the valuation of equity market on the basis of PB Ratio and the implications of same on future expected return.

Current and long term average of PB Ratio for Nifty 50 & NSE 500:

The above table shows that current PB Ratio of Nifty is 3.21 and median PB Ratio is 3.4 (Median is favoured over average as it reduces the impact of outliers). Since current PB Ratio is below long term median, it can be said that Nifty is undervalued.

Similarly, for NSE 500 which is a broader and preferred index, the current PB Ratio is 3.05 and median PB Ratio is 3.04. This shows that broader equity market is fairly valued.

Scatter Plot of NSE 500 and 5 Years Return

The above scatter plot shows the relationship between PB Ratio and investment return after 5 Years. The above chart shows that correlation between PB Ratio and 5 years return is high and both of them are inversely proportional. When PB Ratio is high then future 5 years return is low and vice versa.

Statistically, R Square (R2) which measures the strength of relationship between two variables is at 70% for the above model. In simple language, PB Ratio can predict next 5 years of return with 70% accuracy. This is meaningful and relevant.

The above scatter plot also shows that at current PB Ratio of 3, the future expected return for next 5 years is ~9% per annum and minimum expected return is ~4% per annum. This is a prediction with 70% accuracy.

Range of Return at different PB Ratios:

The above table shows average, maximum and minimum 5 years return at different PB Ratios. The average 5 years return in equity is 11%. The return increases when investment is made at low PB Ratio and reduces when investment is made in high PB Ratio.

Investment Implications:

The key investment implications from above study are as under:

1) Currently, equity market is fairly valued. The market has run up since correction in March, 2020. But despite the rally, equity market is not in overvalued zone. Its not the time to reduce equity exposure but to stay invested in Equity.

2) Exposure in equity should be changed based on PB Ratio valuation. Future 5 years expected return is inversely proportional to PB Ratio. Accordingly, exposure should be increased in equity at low PB Ratio and decreased at high PB Ratio.

3) Since, current PB Ratio of NSE 500 is close to long term average, investors are recommended to stick to their policy Asset Allocation. 

Happy Investing!

Neeru Seal & Dr. Mukesh Jindal

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