Why Indian firms’ valuation premium may be unsustainable

High growth expectations from emerging markets such as India, coupled with sustained foreign investment inflows, have seen the valuation of many India-listed stocks move up sharply. Frontline India-listed companies such as Hindustan Unilever and Maruti Suzuki, for instance, trade at a stiff premium over their global parents/peers (see table).

But with Indian retail investors now having convenient ways to invest in stocks listed overseas, it may be worthwhile to assess the valuations vis-à-vis growth prospects of Indian companies against global peers’ before taking the plunge.

What drives the valuation?

Says Shyam Sekhar, Chief Ideator and founder ithought Financial Consulting LLP: “Premium valuation in frontline Indian stocks was a trend that began around 2012, driven by expectations of a fall in inflation which would improve purchasing power and drive consumer spending. Further, scarcity of quality stocks and engines of passive investing have enhanced this trend.”

Another market veteran who runs a PMS (Portfolio Management Service) business feels that India’s better demographics and upward mobility of consumers uniquely benefits sectors such as FMCG, which is not the case in rest of the developed world where they face market saturation. This, according to him, is a key driver for the higher valuation of Indian stocks.

But the valuation premium of Indian stocks may not be supported by earnings, going by 10 years’ data. India’s earnings growth (CAGR) over the last decade, as represented by the bellwether Nifty 50 index, lags growth seen in developed markets such as the US. The S&P 500 companies’ earnings CAGR from calendar year CY2010 to CY 2019 was 6 per cent vs the 4 per cent earnings CAGR of Nifty 50 companies’ from FY 2011 to FY 2020 (adjusted for Covid impact in Q4 of 2020).

Will it sustain?

Given this, will the premium valuations sustain? How far into the future should an investor look before deciding whether to invest in an Indian company or in its global peer? Consider these two examples. HUL’s market cap in India is close to 50 per cent of the market cap of Unilever Plc. But its current profit is just 15 per cent of Unilever Plc’s profits. Based on the last 10 years’ earnings CAGR of HUL – around 11 per cent – it would require another 10 years for it to reach 50 per cent of Unilever’s current profits. Avenue Supermarts’ market cap is close to $25 billion when its revenue is around $3 billion. When Walmart was a $20 billion market cap company, its revenues were around $30 billion.

Experts say that the valuations and businesses of Indian companies are not infallible. However, they say that certain sectors can do well in this decade vs the last 10 years, and in such cases, the current valuation premium may be justified. At the same time, certain other sectors such as automobiles could be prone to disruption from greater adoption of electric and autonomous vehicles, and the premium may not sustain.

Considering the geographical diversification option available to investors today, better analysis and comparison with global peers could give more bang for their buck. As markets get more globalised, a convergence of valuation differentials based on relative prospects cannot be ruled out.