Red alert: Indian stocks are now the priciest

The Indian stock market, along with its global peers, witnessed a steep sell-off in February and March this year, but the rebound in April has erased a large part of these losses.

However, with the Indian benchmark index, the Nifty 50, once again edging close to its life-time high, the valuation of Indian stocks appears to be the priciest when compared to other global markets.

The Indian market was quick to regain lost ground in April, limiting the loss in Nifty 50 from its January peak to just 4.3 per cent. This performance is superior to the Chinese market benchmark, the Shanghai Composite Index, which is still 14.5 per cent lower and the US’ S&P 500, which trades 7 per cent below its recent peak.

Many of the other emerging market indices such as Korea’s KOSPI, Brazil’s Bovespa and Malaysia’s FTSE Kuala Lumpur Composite Index have, however, managed a smart recovery, similar to India’s.

Concerns over rebound

The rebound in Indian stocks, however, has revived concerns about their valuation. The relentless rally in the market over 2016 and 2017, caused by the surge in domestic liquidity, has taken stock prices far higher than what their earnings warrant.

The price-earnings (PE) multiple of the Nifty 50 is currently 23 times its trailing earnings, the highest among all global benchmarks, according to Bloomberg.

With the exception of the S&P 500, Jakarta Composite and the Bovespa, the PE multiples of most other global indices are less than 20 times. The Nifty 50’s current PE multiple puts it at a 15 per cent premium to its five-year average.

On other metrics too

The Nifty 50 appears expensive when weighed on other parameters, too. The index is trading at 3.2 times its book value. Only the S&P 500 currently sports a similar valuation; all other indices are trading at less than 2.5 times their book value.

What this means

This implies that Indian stocks are demanding a higher value for the assets reported in their books. Similarly, on the price-to-sales ratio, too, the Nifty 50 is being valued at a premium to other global benchmarks.

One valuation metric that is particularly flashing red is the price-to-cash flow ratio. The Nifty 50 is trading at a price/cash flow multiple of 28 times, a steep premium to its five-year average of 19.4 times. All other global indices are trading at multiples below 15.

This ratio suggests that Indian businesses are not able to generate as much cash flow as they did earlier, perhaps due to stretched payment cycles or lower capacity utilisation owing to flailing demand.

The bloated bad loans of domestic banks may also be partly explained by this ratio.

Another metric that is of particular interest to foreign investors is the dividend yield. The Nifty 50’s yield is among the lowest, at 1.25 per cent.

The outlook

While higher growth prospects can partly explain the premium valuation of Indian equity, they appear fully priced at these levels.

Foreign investors are showing signs of wariness: their net purchases in Indian equity to date in 2018 are 78 per cent lower than in the same period last year. Mutual fund purchases in the equity market have also been sharply down in the first four months of this year.

While some consumption-driven sectors may continue to post good growth, the problems facing banks is unlikely to disappear in a hurry.

With private capex cycle yet to revive and the government likely to go slow with investments ahead of Assembly and general elections, demand is unlikely to pick up, and earnings growth could be restricted to some pockets.

All this calls for greater caution from investors.

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