Are current market valuations justified?

With stock prices falling, Indian markets have become cheaper. But does that make them more attractive?

Valuations of the CNX 500 index, as measured by price-to-book value, have indeed declined steeply in five years. They have dropped from 5.5 times to barely 2 times. Over the last five years, the ratio has been at 2.6 times.

But at this discount, are Indian stocks a good ‘buy’?

Not necessarily.

The return on equity, or the profit generated on every rupee of capital invested in Indian companies, has steadily declined over four years.

The return on equity (ROE) of the companies in the CNX 500 has fallen from 23 per cent in March 2008 to just 15.5 per cent by March 2012.

Lower shareholder returns, which is what a falling ROE implies, suggest that investors should pay less in terms of valuation multiples for these companies. But that is not all; profit growth for Indian companies has slowed in the last four years.

Yet, current stock valuations imply a high earnings growth — similar to what they were indicating during the market peaks. This indicates that there is a possibility of more downside to the broader market.

If one is keen to make long-term investments, one has to scout for stocks with attractive valuations that have bucked the trend of falling ROEs.

Behind falling ROEs

To analyse trends in ROE, we started out with 2007-08 numbers, a year of strong growth and high valuations for India Inc.

With that as the starting point, ROEs for CNX 500 companies (excluding banks and finance companies) have tumbled from 24.2 to 15 per cent.

A break-down of numbers shows that much of the decline in ROEs of companies (excluding finance companies and banks) was due to the fall in net profit margin. Moderation in leverage, that is, higher use of equity funding than debt, also diluted ROEs.

The net profit margin of CNX 500 companies declined from 11 per cent to 6.6 per cent over four years. While operating profit margins also suffered some dent due to higher raw material costs, higher fixed costs substantially reduced net profit margins.

Rise in depreciation is indicative of companies adding to fixed assets. But, earnings haven’t kept pace with growth in assets.

Interest costs alone have risen at a 30 per cent CAGR during the last four years though companies managed to reduce their dependence on debt for funding needs.

Consequently, the annual growth of 18 per cent in net sales couldn’t translate into a robust growth in profits. Net profit growth during the four-year period was at a modest 4 per cent.

The decline in ROE, however, wasn’t uniform. Over two-thirds of the companies have witnessed decline in ROEs over the four-year period. Some sectors fared worse than others. Construction, realty, capital goods and telecom sector witnessed higher rate of decline in ROE.

But banking and finance companies, a few of the mid-tier IT companies and auto companies actually witnessed improvement in ROEs.

DLF, JSW Energy, Tata Steel, Idea Cellular and Unitech were some large-cap companies that saw their ROE decline sharply.

Of this, companies in sectors such as hotel, shipping, steel, capital goods and realty were amongst the ones that witnessed significant fall in their profitability due to fall in net margins.

For instance, the ROE of DLF declined from 67 per cent in 2007-08 to 4.4 per cent in 2011-12 after the net margin of the company declined to 12.4 per cent from 54 per cent.

Similarly, Unitech, HDIL and other realty stocks have also witnessed sharp decline in net margins.


The debt-equity ratio of CNX500 companies declined from 0.72 to 0.57 times in the four-year period. This should have ideally helped ROE.

The equity capital for Indian companies has expanded at twice the rate of debt funds over four years. Retained profits and fresh equity capital helped expansion in equity.

Companies such as Adani Enterprises, Aurobindo Pharma, Bajaj Electrical and Tata Steel are a few companies that have reduced their leverage ratio significantly and have seen moderation in return on equity.

Sufferers, survivors

Within the universe, non-finance companies witnessed a decline of ten percentage points in their return on equity. There was only a percentage point decline in ROEs of banking and finance companies.

The ROEs of non-finance companies and finance companies were 14.5 per cent and 15.8 per cent, respectively, for the recently concluded fiscal.

Larger companies as represented by CNX 100 continue to enjoy better ROE than mid-cap companies.

The ROE of large companies (excluding financials) was 16.7 per cent compared with 10 per cent in the case of mid-sized companies.

Higher interest costs were the key reason for mid-sized companies faring worse.

Interestingly, with their ROE at 10 per cent and high borrowing costs, it doesn’t make sense for mid-cap companies to add leverage at this juncture as it may not benefit ROEs.

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(This article was published on July 28, 2012)
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