The Hindu Business Line : Numbers point to cheap valuations

IN THE aftermath of the September 11 disaster in 2001, stock prices sank across the globe. While markets are traversing a higher orbit now in terms of index values, the ruling valuations are comparable to the uncertain times post 9/11.

The PE multiple of the BSE-100 index at the end of September 2001 was 13.7. It is now 13.4.

These numbers indicate that long-term investors should not be carried away by the prevailing negative sentiment and unduly high volatility.

They need to focus on companies' earnings and valuations and whether these match their expectations. For long-term equity investors, this may just be an opportunity buy into a few sectors.

More on the numbers: Earnings of BSE-100 companies at the end of March 2004 have risen more than 100 per cent compared to their level at the end of March 2001.

In a sense, earnings growth has kept pace with that of stock price growth.

Valuations measured in terms of price to earnings ratios have, therefore, not risen even as index levels are far higher than they were in end 2001.

To an extent, however, the price to earnings ratio may be misleading because the efficiency with which the assets were utilised (return on net worth) may have gone down.

In addition, one may also need to factor in the level of dividends paid out by the companies. As such, the PE multiple may need to be adjusted.

Thus, multiplying the PE ratio with the price to book value and dividing it by the dividend yield will provide us a cumulative score.

This cumulative score, which is by no means perfect, is a more meaningful to way measure valuations.

This cumulative score tells us that in the case of BSE 100 index:

Valuations hit an all-time low in October 2002 and not in October 2001.

Valuations now are double what they were in May 2003, when the present rally began — an indication of what was behind the bull-run between May 2003 and January 2004.

Between April 2004 and now, stock prices are down only about 15 per cent.

Valuations, though, are down nearly by half, thanks to rising earnings and dividends.

Valuations now are similar to what they were in August 2001 and August 2003.

The values for Sensex, which represent large-cap stocks, are largely similar.

Valuations now are not double what they were in May 2003 but are about 60 per cent higher.

Between April and now, valuations have dipped more than half (about 55 per cent).

Valuations are similar to the levels seen in August 2003 but are about 10 per cent lower than they were in August 2001.

Growth over March 2004: Prima facie, these valuations look alluring. Maybe over a sufficiently long term, returns to an equity investor may even touch about 15 per cent per annum — a number touted by most fund managers.

Direct investors in the stock market, however, need to do more homework. What needs to be established is if the earnings for the year ended March 2004 are sustainable.

That is important because it is those earnings that make valuations look attractive.

What needs to be firmly established is whether reasonable growth of about 10-15 per cent over the next five years can be generated over the earnings for the year ended March 2004.

If such a probability is high, this is definitely the opportunity to buy.

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