Using the inverse of P/E to read markets better

With the local stock markets rallying more than 65% from the bottom seen in March 2009, the “valuation debate” is back in vogue. Though absolute valuations are always debated, relative valuations are hardly discussed. We shall discuss relative valuations here. But first some basics.

A traditional method used to value stocks for years now is the price to earnings (P/E) ratio. It is the multiple of the earnings the stocks or markets in general are valued at. The key question here is — how many times the earnings is the market willing to pay to buy a certain stock?

The P/E ratio may be based on historical or estimated earnings. Earnings can be estimated with minimum assumptions (such as GDP growth rate), historical data and growth rate. The current P/E ratio is then compared with its own historical averages to value the individual stock or markets.

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