Investing Using PE Mean Reversion

Dr. Ruzbeh Bodhanwala

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Every fund manager and investor wishes to earn more than the BSE Sensex return, which in technical parlance is referred to as generating alpha. There are many investing techniques using which investors try to earn excess return - one such technique is mean reversion'. This technique of investing believes that every stock reverts to its long-term mean PE ratio and by selecting stocks which are trading below their long-term average PE ratio we can maximise our returns. The PE multiple (price to earnings ratio) has been one of the most popular approaches to equity valuation. The PE ratio of a company is calculated by dividing the current market price of the share with its earnings per share (EPS).

In order to do so we need to observe the historical PE ratio and invest in shares which are trading below their long-term average PE. If the company is good on financial parameters and the management of the company is sound, the PE ratio will increase and definitely cross its long-term PE ratio, thereby generating higher returns for the investor. Many a times, we hear investors talking about Nifty and Sensex touching their all-time highs which is very similar to someone comparing the housing price of today with the price of a house in 2001 and realising that to buy a house as of now is much more expensive.