PE Rerating and Derating: Understanding Market Liquidity and How to Navigate as an Investor - Rich Mindset and You

As a retail investor, you may have come across the terms "PE rerating" and "PE derating" and wondered what they mean and why they matter. In this blog, we'll explore these concepts, what they mean for investors, and why a failure to understand them can result in significant losses.

What is a Price-to-Earnings Ratio (PE Ratio)?

Before we dive into PE rerating and derating, let's first understand what a Price-to-Earnings Ratio (PE Ratio) is. The PE Ratio is a financial ratio used to measure the value of a company's stock relative to its earnings. In other words, it's a way to determine how much investors are willing to pay for each dollar/Rupee of a company's earnings.

To calculate the PE Ratio, you take the market value per share of the stock and divide it by the earnings per share (EPS) of the company. For example, if a company's stock is trading at $50 per share, and its EPS is $5, then its PE Ratio is 10 ($50/$5).

The PE Ratio is often used as an indicator of a company's valuation. A high PE Ratio may suggest that a company's stock is overvalued, while a low PE Ratio may suggest that a company's stock is undervalued. However, it's important to note that the PE Ratio is just one of many factors to consider when evaluating a company's stock.

PE Rerating

Now that we understand what a PE Ratio is let's explore what PE rerating means. PE rerating refers to a situation where the market increases or decreases the PE Ratio of a company's stock. This can happen for a variety of reasons, such as changes in the company's earnings, changes in the market's perception of the company, or changes in market conditions.

For example, suppose a company's stock has a PE Ratio of 15, and the market expects the company's earnings to increase significantly in the future. In that case, the market may increase the PE Ratio to 20, resulting in a PE rerating. Conversely, if the market expects a company's earnings to decrease in the future, it may decrease the PE Ratio, resulting in a PE rerating.

PE rerating can have a significant impact on a company's stock price. If the market increases the PE Ratio of a company's stock, the stock price may increase, even if the company's earnings remain the same. Conversely, if the market decreases the PE Ratio, the stock price may decrease, even if the company's earnings remain the same.

Why is PE Rerating Important?

PE rerating is important because it can have a significant impact on a company's stock price. As a retail investor, it's important to understand the factors that can cause PE rerating so that you can make informed investment decisions. For example, if you're considering investing in a company's stock, and the market is expecting a significant increase in the company's earnings, you may want to consider investing before the PE rerating occurs to take advantage of potential price gains.

PE Derating

PE derating is the opposite of PE rerating. It refers to a situation where the market decreases the PE Ratio of a company's stock. This can happen for a variety of reasons, such as a decline in the company's earnings, changes in the market's perception of the company, or changes in market conditions.

For example, suppose a company's stock has a PE Ratio of 20, but the market becomes concerned about the company's future earnings growth. In that case, the market may decrease the PE Ratio to 15, resulting in a PE derating. Conversely, if the market becomes more optimistic about a company's future earnings growth, it may increase the PE Ratio, resulting in a PE rerating.

Why is PE Derating Important?

PE derating is important because it can also have a significant impact on a company's stock price. If the market decreases the PE Ratio of a company's stock, the stock price may decrease, even if the company's earnings remain the same. As a retail investor, it's important to understand the factors that can cause PE derating so that you can make informed investment decisions. For example, if you're considering selling a company's stock, and the market is expecting a significant decrease in the company's earnings, you may want to consider selling before the PE derating occurs to minimize potential losses.

PE Rerating and Derating in Practice

To illustrate the impact of PE rerating and derating, let's take a look at a real-world example. In 2016, Apple Inc. experienced a PE rerating. The company's stock had been trading at a PE Ratio of around 10 for several years. However, in 2016, the market became more optimistic about the company's future earnings growth, and the PE Ratio increased to around 15. This PE rerating resulted in a significant increase in Apple's stock price, even though the company's earnings remained relatively stable.

On the other hand, let's look at another example of a company that experienced a PE derating. In 2018, Facebook Inc. experienced a significant PE derating. The company's stock had been trading at a PE Ratio of around 30 for several years. However, in 2018, the market became concerned about the company's handling of user data and the potential impact on future earnings growth. This led to a decrease in the PE Ratio to around 20, resulting in a significant decrease in Facebook's stock price.

Market Liquidity Impact

PE rerating and derating are important concepts that impact a company's stock price, but they are not the only factors to consider. Another important factor to consider is market liquidity.

Market liquidity refers to the ease with which assets can be bought or sold without significantly impacting the asset's price. In a highly liquid market, there are many buyers and sellers, and assets can be bought and sold quickly and easily. In a less liquid market, there are fewer buyers and sellers, and assets may take longer to buy or sell.

Market liquidity can impact the price of a company's stock, especially during periods of high volatility. If a company's stock experiences a sudden increase in demand, but there are few buyers, the price may increase rapidly. Conversely, if a company's stock experiences a sudden increase in supply, but there are few sellers, the price may decrease rapidly.

The relationship between market liquidity and PE rerating and derating can be complex. In a highly liquid market, PE rerating and derating may have less of an impact on a company's stock price because there are many buyers and sellers. However, in a less liquid market, PE rerating and derating may have a greater impact on a company's stock price because there are fewer buyers and sellers.

For example, let's say a company experiences a significant increase in earnings, leading to a PE rerating. In a highly liquid market, there may be many buyers interested in purchasing the company's stock at the higher price, which may help to stabilize the stock price. However, in a less liquid market, there may be fewer buyers interested in purchasing the stock at the higher price, which may lead to a more significant increase in the stock price.

Similarly, if a company experiences a significant decrease in earnings, leading to a PE derating, the impact on the stock price may be greater in a less liquid market. In a highly liquid market, there may be many sellers interested in selling the stock at a lower price, which may help to stabilize the stock price. However, in a less liquid market, there may be fewer sellers interested in selling the stock at a lower price, which may lead to a more significant decrease in the stock price.

To mitigate the impact of market liquidity on your investments, it's important to consider the liquidity of the market and the assets you're investing in. Investing in highly liquid assets can help to ensure that you can easily buy or sell the assets without significantly impacting the asset's price. Additionally, diversifying your portfolio across different asset classes and sectors can help to reduce your exposure to the risks associated with market liquidity.

One interesting aspect to note is that a PE rerating or derating is not always solely due to a company's financial performance and Market Liquidity. External factors such as changes in market sentiment, regulatory changes, or macroeconomic conditions can also impact a company's PE ratio. As such, it is essential to have a holistic understanding of a company's underlying fundamentals and its operating environment when assessing its potential for rerating or derating. Additionally, looking beyond just the PE ratio and considering other valuation metrics such as price-to-sales and price-to-book ratios can provide a more comprehensive picture of a company's valuation.

Here are some steps investors can take to avoid being swayed by PE rerating and derating:

Do your research: Before investing in a company, it's important to do your due diligence and research the company's financials, management team, industry trends, and other relevant factors. By understanding the underlying fundamentals of the company, you can make informed decisions that are not solely based on short-term market movements.

Focus on long-term goals: Instead of trying to time the market or make short-term trades based on PE rerating and derating, focus on your long-term investment goals. Develop a strategy that aligns with your financial goals and risk tolerance, and stick to that strategy over time. Avoid making impulsive decisions based on short-term market movements.

Diversify your portfolio: Diversification is key to managing risk in your investment portfolio. By investing in a mix of asset classes and sectors, you can reduce your exposure to the risks associated with individual stocks and market movements.

Ignore the noise: The financial news media can be full of noise and hype around market movements and individual stocks. It's important to tune out the noise and focus on the fundamentals of the companies you invest in. Don't let the hype around PE rerating and derating sway your investment decisions.


Seek professional advice: If you're unsure about how to navigate market movements and PE rerating and derating, seek the advice of a professional financial advisor. An experienced advisor can help you develop a long-term investment strategy, manage risk, and make informed decisions based on your financial goals and risk tolerance.

It is worth noting that PE rerating and derating can also have a ripple effect on other financial markets beyond the stock market. For instance, changes in the valuation of companies can impact the fixed income markets by affecting credit spreads and bond yields. This, in turn, can influence the cost of capital for companies and potentially impact their ability to issue debt. As such, investors should keep an eye on the broader financial market and consider how changes in company valuations may impact their portfolio allocation and risk management strategies. Additionally, staying informed about market developments and continuously monitoring the performance of investments can help investors stay ahead of potential risks and opportunities
In summary, PE rerating and derating are important concepts to understand when investing in stocks, but they should not be the sole factor in your investment decisions. By taking a long-term perspective, focusing on the fundamentals of the companies you invest in, diversifying your portfolio, and seeking professional advice, you can avoid being swayed by short-term market movements and make informed investment decisions that align with your financial goals.