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Suresh Krishnamurthy

Robust earnings expectations are behind the price surge of a majority of stocks. In fact, the valuations of most stocks resemble those of growth stocks now. Conservative investors may find the associated risks unpalatable.

THE Madras Cements stock is now trading at a multiple of 53 times its earnings for the year ended March 2003. Does this strike you as bizarre? It is not. Such fancy multiples are based on the expectation of an earnings growth rate of 289 per cent in 2003-04. In fact, it is such robust expectations that are behind the bull-run in stock prices.

Prima facie, these earnings growth expectations lend credence to claims that stocks are not overvalued, even now. However, it is difficult to take a view on the market as a whole. Investors need to work out the earnings expectations behind each stock and decide if they are justified before they consider any investment action.

A PEG of one: In terms of conventional parameters, stocks may now appear overvalued. For instance, the average price-earnings multiple of a set of 75 stocks chosen for the analysis was about 17 — a number that does not tell the whole story.

The multiple needs to be adjusted for earnings growth. And this is where the PEG ratio comes in handy. The PE multiple is divided by expected earnings growth to arrive at the PEG ratio.

A PEG ratio of less than one signified that the stock was properly valued or undervalued. A PEG ratio far removed from one signified that the stock was overvalued. The average for Indian stocks is now tantalisingly poised at a PEG ratio of just above one.

Of the 75 stocks for which analyst estimates of earnings were available in Bloomberg, only 23 trade at a PEG of more than one. These 23 stocks, however, account for about 60 per cent of the market capitalisation. In effect, stocks accounting for about 40 per cent of the market capitalisation and which form the bulk of the listed issues are now trading at PEG ratio of less than one.

Stocks that are trading at a PEG of substantially more than one include Colgate Palmolive, Hindustan Lever, Wipro, Tata Steel, ABB and HDFC. Stocks trading at a PEG of much less than one include Canara Bank, Oriental Bank of Commerce, Lupin, Indian Hotels, Grasim, Tata Motors and Bharat Electronics.

Potential upside: A ratio of less than one for a majority of stocks suggests that there is some steam still left in the rally. If you consider that usually stocks stray away from their intrinsic value (sometimes substantially), it may be some time before the rally peters out.

However there are a few caveats. The efficacy of PEG ratio in identifying undervalued or overvalued stocks has not been proved conclusively. The PEG ratio is a crude financial tool that will point you in a particular direction. Further analysis will be required to unearth a stock's true value. The only consolation is that the PEG ratio is a much better tool than the PE ratio.

Rosy expectations: Importantly, unreliable earnings expectations can also make PEG ratios fallible. During heated stock market rallies, expectations are generally unjustifiably optimistic. This may be true of this bull run too.

The case of Infosys illustrates this point. The market expects Infosys to achieve earnings of Rs 180 per share for the year ended March 2004. However, the company has itself set a target of only about Rs 170 per share.

There are other companies from which much is expected. There are 36 other stocks whose earnings are expected to grow at more than 30 per cent. Not surprisingly, these stocks have notched blistering price growth in recent months.

As things stand, there is no escape from considering such `growth stocks'. This is because there are only a handful of stocks whose expected earnings growth is nominal and whose PE is lower than expected earnings growth.

A few such stocks are Tata Power, IPCA Labs, Container Corporation and a host of banking stocks. In most other stocks, either the PE is higher than earnings growth or earnings growth is itself at a level higher than say 30 per cent. If you are wary of such growth stocks, the stock market is now not the place for you.

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