Nifty rejig and the problem with index-based valuation

Subscribe to enjoy similar stories. Changes to the benchmark Nifty50 index will be effective from 28 March. Jio Financial Services Ltd and Zomato Ltd will replace Bharat Petroleum Corp.

Ltd (BPCL) and Britannia Industries Ltd. The reshuffle will alter the index’s price-to-earnings (P/E) multiple and revive the debate over whether Nifty’s valuation is expensive or justified—particularly among fund managers who rely on index-based valuations for capital allocation to countries. But how useful is index-based valuation? To answer that, it is essential to understand how Nifty constituents are selected and how index valuation is calculated.

Read this | Nifty reshuffle: Zomato and Jio Financial could edge out Britannia and BPCL in India's benchmark index The Nifty index includes companies with the highest free-float market capitalization—that is, market cap excluding the valuation of shares owned by promoters. However, from the index valuation perspective, the total market capitalization of companies should be considered. This means the combined market cap of companies entering the index should be compared with that of the companies being replaced.

How is the index valuation arrived at? Unlike individual companies, the index’s earnings per share (EPS) isn’t directly available. Instead, Nifty’s P/E ratio is calculated by dividing the aggregate market capitalization of all constituents by their aggregate net profit. The index’s EPS is then derived by by dividing the Nifty index value by its P/E ratio.