During the process of index investing, you may often hear the term "valuation level." But what exactly is valuation?

Simply put, valuation is the assessment of an asset's value. The price-to-earnings ratio (P/E) is the most common valuation metric and is often referenced when analyzing index valuations. It represents the price investors are willing to pay for each unit of earnings. For some sector indices, other valuation metrics can also be considered based on industry characteristics to gauge the index's valuation level. For example, for growth-oriented indices with distinct features, the price/earnings-to-growth ratio (PEG) can be used. Some industries exhibit significant cyclical fluctuations, or the book value of tangible assets of constituent stocks has a substantial impact on the company's market value—such as banking and construction materials—where the price-to-book ratio (P/B) can be referenced, reflecting the price investors are willing to pay for each unit of net assets. Meanwhile, for industries experiencing rapid growth but not yet profitable, with high R&D investment and asset-light business models, the price-to-sales ratio (P/S) can be used to understand the index's valuation level.

How can we determine whether a valuation level is high or low?

First, you can compare horizontally. After understanding the specific valuation of an index, you can compare it with other indices (such as benchmark indices like the CSI 300) to see whether the relative valuation level is historically high or low.

Second, you can compare vertically. In other words, compare the current valuation with the historical valuation of the same index by ranking the index's valuations over a certain period from low to high and identifying the current percentile. Note that the selected time frame—whether 3, 5, or 10 years—will affect the calculated valuation percentile. Investors should observe multiple time dimensions for a more comprehensive comparison.

Take the ChiNext Index as an example. As of November 18, 2022, its trailing P/E ratio was 40x. Over the past 3 years, the index was at the 1st percentile of its valuation range; over the past 5 and 10 years, it was at the 15th and 13th percentiles, respectively. This suggests that the ChiNext Index's valuation was at a historically relatively low level. Additionally, you can compare the ChiNext Index's valuation horizontally with indices like the CSI 300 to observe changes in the valuation gap between the two. For instance, when the ChiNext Index's valuation premium over the CSI 300 reaches a historically high level, it may indicate that the ChiNext Index is relatively "expensive" and carries some risk of valuation correction.