Investors must, today, pay lower multiples for stocks than they did a few years ago.

Market commentators today often ask you to bet on stocks because they look cheap relative to their historical valuations.

But is history really relevant? May be not.

The falling shareholder returns on Indian stocks indicate that investors must today pay lower multiples for stocks than they did a few years ago.

The current price-to-book value of CNX100 and CNX500 indices are at 2.3 times and 2 times, respectively. Price to book value is actually derived from return on equity, cost of equity and expected growth in earnings per share.

Breaking down today’s multiple into these components shows that investors are factoring in high earnings growth for CNX500 companies at these valuations.

Consider the return on equity of close to 15 per cent and cost of equity of 13 per cent (8 per cent risk-free rate plus a risk premium of 5 percentage points).

The current price-to-book value of 2 times for the market then implies 11 per cent growth in net profits for these companies for perpetuity.

Now, this is a bit steep as sustaining double-digit earnings growth even for a multi-year period is quite a hard task.

The current implied earnings growth is similar to expectations during the market peaks.

Mid-caps at risk

This argues for two things. One, stocks, across the board, are not really attractive. And therefore, only select companies which have better profitability and lower price-to-book value (see table), may offer good potential to investors.

Additionally, large caps are more attractive than the mid-caps. Mid-cap stocks have seen dwindling shareholder returns and sport a current price-to-book ratio of 1.7 times.

Though a high growth in earnings for a few years would otherwise justify these valuations, the mid-cap companies have seen their earnings dip during the last four years.

Market estimates suggest that earnings growth of mid-cap companies (17 per cent compounded annually over the next three years) is expected to be higher than larger companies.

But, the risks are far higher to the earnings estimation in case of mid-cap companies. With nominal GDP growth expected to be lower in the next five years than the last five years (IMF estimates), rates of growth may be slow.

Therefore, performance of Indian companies, especially the mid-cap companies, can only improve when economic growth revives and interest rates come down. Therefore investments in these stocks are best made after a significant price correction.

ALSO READ: Shareholders get less from Indian companies

(This article was published on July 28, 2012)
XThese are links to The Hindu Business Line suggested by Outbrain, which may or may not be relevant to the other content on this page. You can read Outbrain's privacy and cookie policy here.