How to identify Bubble?

What are the main characteristics of a bubble? How can an investor identify early and take advantage or avoid getting punished? Let me give you some examples which can be used to give a fair idea of a bubble in terms of P/E ratio.

All the gurus agree that 21,000 Sensex in January 2008 was nothing but a bubble. What did the valuation look like at that time? The five companies in the Sensex that led this bull market were trading at following valuations:

Company	P/E of TTM EPS	P/E of 10 year average EPS
Reliance	30	70
Larsen & Toubro	56	135
ICICI Bank	35	80
Bharti	32	150
NTPC	30	45

Companies were trading at 70-140 times ten year average EPS. When the markets corrected many good companies without any debt on their balance sheet giving good dividend in BSE500 were available at TTM P/E of 3-5 with a P/E of 10 year average EPS of less than 5. The examples were Patni and Maharashtra Seamless. Even Bharat Electronics and BEML were available at P/E of 10 of average EPS of 10 years.

The fact shows that investors were paying too much for the near term growth in profits and were not taking into the account the impact of business cycles. The period between 1999-2003 was such that corporates were earning less than their potential but between 2006-2007, most of the companies were earning above their potential.

Can I locate similar trends in some sectors today? Have a look at the following table to compare valuations of some companies:

Company	P/E of TTM EPS	P/E of 10 year average EPS
ABB	31	60
Bharti	19	70
BHEL	33	76
Colgate	29	63
Dabur	29	61
Educomp	50	260
GMR	87	267
GSPL	27	80
GVK Power	35	150
India Infoline	18	76
Jain Irrigation	33	89
JP Associates	55	84
KSK Energy	50	287
Mundra Port & SEZ	50	225
Nagarjuna Fertilizer	75	135
NMDC	31	97
RNRL	188	775
Titan	34	95

Many of the stocks seem to be related to Ports, Airports, Metals, Education and Power. Some overvaluation in FMCG has also started to appear. Manish Chokhani says that there might be companies in power sector that grows from small caps to be a part of Sensex one day replacing NTPC similar to what happened in Telecom. But isn't that hope priced in at this point of time?

The overvaluation of stocks can continue for a long period of time since the liquidity chasing the equities is in huge amount. Investors should stay cautious.