This is the million dollar question for which all of us are seeking an answer..

My honest answer: *I don’t know.*

Possible Truth: *No one really knows..*

While I humbly acknowledge my inability to predict the future, the other side of the view i.e “I can’t predict. So I will just hang on to equities and well just..Pray!” somehow just doesn’t seem to be a great stance either.

So let us see if we can come up with a framework to set our expectations on equity returns. And based on how reality turns out, we can always come back to this framework and evolve it.

So here we go..

### Anchoring to Sensex levels

One of the common mistakes that most of us do, is to decide based on the Sensex levels. We check for the Sensex levels, listen to what our intuition has to tell on whether it is expensive or cheap and then go ahead based on that.

Today the Sensex is around 31,000 levels. What does your intuition tell you?

*“The Sensex has never been around these levels. It looks expensive and I feel it will fall from these levels” – says my intuition.*

But unfortunately, this method of trusting our intuition, while holds good in certain other areas of life, is a very bad method when it comes to investing.

In 2008 beginning, the Sensex was around 20,000 levels. And then it crashed by 60% due to the global financial crisis.

Then in 2010 end, Sensex was around 21,000 levels. Again it crashed by 26% on concerns over the Euro debt crisis.

And then as expected, the levels of 20,000 in Sensex had gotten anchored strongly in the minds of all of us as a crash-for-sure-level. As it crashed 2 times earlier, our intuition started to believe that the Sensex at 20,000 levels was the reason for the crash.

And obviously, the next time Sensex hit 20,000 in 2013, no wonder most of us were reluctant to invest.

Today at Sensex level of 31,000, we all know what happened next 😦

Under the influence of the Sensex value, we were no better than this man searching for his keys.

So now that we know that the Sensex is a misleading number, is there a better way?

**Elon Musk to the rescue**

Elon Musk touches upon an interesting framework for solving problems called the **first principles. **

It simply says “to solve any problem, **you need to break things down to the most fundamental truths (i.e basic underlying components or ingredients) and then solve up from there”.**

**What would be the first principles equivalent of equity returns?**

Instead of getting carried away by the Sensex number, we are simply going to break down the Sensex into its underlying two components:

**Sensex Value = Profit of underlying companies * Valuation (i.e no of times the profit that you are willing to pay)
**

or in precise geek terms it reads as

**Sensex Value = Earnings Per Share for Sensex * PE Ratio**

**EPS (Earnings per share for Sensex)**represents the underlying profits of the Sensex companies per share**PE Ratio (Price Earnings Ratio)**– This is the valuation or the no of times the underlying profit that the investors are willing to pay

The key takeaway here is that the

*Sensex value can be alternately viewed as the product of two numbers – EPS and PE ratio*

(Actually there is also dividends which get added to returns which for the sake of simplicity we won’t consider here. For Sensex it’s mostly around 1.5% range)

So when we want to evaluate future returns for equities we are essentially asking the question “How much will the sensex value change?” or in other words “How much will the EPS and PE ratio change? “

Change in Sensex value = Change in EPS * Change in PE Ratio

So basically predicting equity returns boils down to answering these two questions

**What can be the earnings growth?****Will the valuations move up (increasing returns) or move down (reducing returns) or stay flat (not contributing to returns)**

**Appreciating valuations..**

Let us start with Sensex valuations..

**What do you notice?**

- Valuations have generally been cyclical (i.e they go up and down but revert back to their average)
- Sensex PE valuations have gone as high as 26 times and as low as 9 times
- The average valuations have been around 18 times

The first time I saw this chart when I began my career, I had my Archimedes moment. While I obviously didn’t go around naked shouting “Ëureka”, finally I had cracked the secret code to equity investing. (or at least that’s what the naive-me believed)

Simple..

**I buy at low PE – equities will immediately go up and sell at high PE – equities will immediately go down!**

Hurray 🙂

The logic as seen above remains simple. Equity valuations keep moving up and down. So whenever it is above average PE it will eventually go down and whenever it was below average it will eventually go up.

And then, as always after all these years of real world investing, I have realized that reality looks a lot different than theory!

My biggest learning:

Valuations are never a timing indicator. They are only a measure of risk!

What the #$%..

Relax. Let me try to explain with the help of an analogy..

Let’s say you have a friend Rahul who is a very reckless driver and always over speeds. (pardon the guy-cycling-just-crossed-me kinda implied speed in the picture above)

He is leaving your office and has to travel another 20km back home and as always he is expected to over speed.

**Now will he meet with an accident on his way back?**

Think for a minute and what would be your answer.

You really can’t be sure about whether he will meet with an accident in this particular journey, right. But if he keeps driving like this, then you can reasonably be sure that sooner or later he will meet with an accident.

This is exactly the same issue with valuations.

A high valuation generally means markets are over speeding. The degree of risk is high.

But as in the case of our friend Rahul, it does not mean markets will go down in the next week, next month, next year. You never know how long it takes!

The only thing you can reasonably be sure is that sooner or later, the chance of a market decline is pretty high.

This distinction is extremely important to view “valuations” from the right perspective.

So now that we are clear on the fact that valuations should be used only to evaluate the degree of risk and not to time the market, let’s deep dive into valuations..

### Evaluating degree of risk via valuations

Current PE valuation of Sensex = 23.5

Historical Average = 18

Current valuations look expensive compared to historical averages.

**But is there a better way to understand this ?**

The basic assumption we will make is that Sensex valuations will revert to their averages gradually.

So if I have a 3 year time frame, I will assume that **valuations** will **revert** to their **average **of around** 18 times**.

Now let us evaluate the impact of this on future returns..

As we saw earlier, returns have two components – valuations and earnings

This table shows the annualized loss in returns due to valuation component if the PE returns back to its historical average for various time frames.

So as seen above, while the absolute loss is 24% if valuations come back to their averages, it gets spread over your investment time frame.

Hence the longer your time frame the lower is the annualised impact of valuation changes.

Going back to the table, if you assume the Sensex gets back to 18X PE and you have a 3 year time frame – this implies a loss of annualized 9% on your overall returns from earnings growth.

This means if the Sensex earnings growth turns out to be 15% annualized for next 3 years, Sensex will only end up with 15%-9%=~6% annualized returns.

But if you extend your horizon to 5 years, then the annualized loss due to valuations reduces to 5%.

Thus as you extend your horizon further, the impact of a valuation decline on overall returns reduces.

This leads us to another interesting conclusion

The longer the time frame, the lesser is the impact of starting valuations – the returns will primarily be driven by earnings growth

Thus based on the current valuations, as shown in the table you can approximately estimate the impact on overall returns assuming that valuations return back to their averages.

**So what do we make out of all this?**

- If
**starting valuations are high, we need to have a longer time horizon** - The key to returns going forward will be earnings growth as expecting valuations to go up from here is a tough ask
- Most probably valuations reverting to their average will imply we will not be able to capture the entire earnings growth as our returns

Sounds good. But I am missing out something here. Can you take a guess?

Clue: Go back and observe the Sensex PE ratio chart

Yes. The sensex very rarely ends exactly at our assumed long term PE average of 18 times. More often than not it overshoots either way – above or below.

This means even if have a fairly reasonable time horizon, say 7 years, my returns will be impacted severely by the ending valuation. Since the valuation has moved between 9 and 26, what if we end up our holding period at 9 time PE 😦

So as always we are stuck. How do we solve this issue?

No worries. Here is an interesting secret about the Sensex valuations –

Historically in any two year period of the last 17 years, the **Sensex has always ended up touching a PE valuation more than 17 times**. (actually PE of 17.7 times is the lowest among the various maximum PE it touched in various two year periods)

In simple terms, this means historically, you have always got the opportunity to exit above a PE valuation of 17x in the last 2 years!

This means if we can view our investment time frame as T+2 years, then in the last 2 years, historically we have always got an opportunity to exit at around 17-18 times PE ratio (no certainty that it should continue. But nevertheless has worked out so far)

Eg:

- Assume you have a
**7 year time horizon**and you plan to**invest in equities** **Don’t touch**your**equity portfolio**for the**next 5 years**- In the
**last 2 years**, is where we start**planning**our**exit** - After the 5th year, you can exit immediately when Sensex is above or crosses 17x PE

Phew. This solves our assumption problem of Sensex not exactly reverting to historical average PE.

While the Sensex won’t end up at average, we can always plan to exit near the average at 17 times PE using our secret insight above 🙂

- Now this implies, we can get a better shot at calculating the impact of valuation component on overall returns
**Your return expectation in the above case of 7 years should be approximately:****Earnings growth****+ 1.5% (Dividend Yield of Sensex)****– 4 to 5% (assuming exit valuations at ~17-18 times PE over the next 5-7 years)**

There you go. Using the above logic and based on the time frame, you can evolve your own return expectation framework.

And for those wondering where to find the PE ratio. No worries IDFC mutual fund has a PE indicator always available at this link below

https://www.idfcmf.com/is-it-a-good-time-to-invest.aspx

Great. So one part of the equity returns puzzle is reasonably solved.

But we are left with the next key question..

**How in the world, do we set our expectations on earnings growth?**

Hang on till the next week 🙂

And as always happy investing 🙂

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**Disclaimer:** All blog posts are my personal views and do not reflect the views of my organization. I do not provide any investment advisory service via this blog. No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments