The Hindu Business Line : Outlook for profit growth rates

THE long-term sustainable profit growth rates of Indian corporates on an average are nearly equal to the growth rates of manufacturing and service sectors plus inflation. Assuming around 8 per cent real growth rates of service and manufacturing sectors and 4-8 per cent inflation, the nominal growth rates work out to 12-16 per cent p.a. However, over the last 3-5 years, profits have grown at higher growth rates of nearly 25 per cent CAGR.

Looking forward over the next 2-5 years the expectations of growth rates range between 12-18 per cent CAGR.

These are lower than past growth rates because the incremental cost savings are relatively small, capital spending is coming back as new capacity needs to be created which will result in a gradual but steady rise in fixed charges, interest rates have bottomed out and there are cost pressures from higher prices of basic materials as also wage inflation.

Finally, an appreciating currency is also not good for margins on balance. A cyclical downturn in commodity prices cannot be ruled out as well. This slowdown in profit growth rates is widely anticipated and is built into analysts' forecasts and is therefore not a cause for concern

Outlook for PE multiples

There is nothing like a "fair" PE multiple (if there was one, then shares would not fluctuate because historic earnings in any case are known; even one-year forward earnings are known with reasonable accuracy).

However, it is possible to take a view on PE multiples whether they are cheap or expensive. Let us look at the different ways to assess PE multiples:

History is a guide (though not always a reliable one). The average PE of Indian markets over last 15 years is around 18 and for long periods our markets have traded between 15-25 multiples. The present PE is nearly 15 times based on March 2006 estimated earnings. Thus at present level of index, the PEs are not unreasonable.

According to a thumb-rule used by the financial community, a PE nearly equal to sustainable earning growth rate is considered reasonable. Considering that earnings growth in foreseeable future is around 15 per cent, a 15 PE is not unreasonable for the markets.

Our PEs are also in line (actually somewhat higher) with the PEs of the region. However, there is a case to be made that Indian PE multiples should actually be higher than PEs of the region.

This is because of higher sustainable economic growth rate of our economy, on account of size and diversified nature of our economy, on account of low leverage in the economy and finally very low dependence on exports, etc. Thus, even from this perspective the PEs are not unreasonable.

There is yet another way of looking at PE multiples. A 7 per cent yield on 10-year G-Sec translates to a nearly 14 PE for a risk free asset with zero growth. Crudely assuming that the growth offsets the volatility of growth rates in equities, a 15 PE is very close to a bond PE and again is therefore, reasonable. In view of the above, it is reasonable to conclude, that the present PE multiples of our markets though are not cheap as they were in the last 2-3 years, but they are neither unreasonable or expensive.

There is also an issue of frame of reference here. For those of us who are comparing the PEs of the last 2-3 years, the present PEs appear to be high but if we were to compare the same with the last 10 years PEs, then present PEs appear to be reasonable.

(Edited extracts from the views expressed by Mr Prasanth Jain, Chief Investment Officer. HDFC Mutual Fund in the latest monthly performance report.)

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