Crisil Research has said that earnings, not order book, will drive the valuations of construction companies.

Though most companies have a healthy order book, valuations have taken a beating due to muted earnings growth mainly due to execution hurdles, hardening interest rates and stretched working capital cycle. In the last one year, construction stocks have significantly underperformed – negative 55 per cent return compared to S&P CNX Nifty's negative eight per cent, it said.

Even though some of these concerns may continue to plague the industry in the near term, Crisil said that at current valuations, which are at historic lows, the risk to reward ratio appears favourable given the growth potential of the sector.

After registering strong earnings growth of about 60 per cent during FY 05-08, construction companies reported just two per cent growth during FY 08-11 due to weak margins and high interest costs. While Crisil expects the earnings pressure to continue to cloud during the current fiscal due to execution hurdles and high interest, it feels that all is not lost. The silver lining is that order awards and execution issues have started showing signs of easing up during second quarter of current fiscal, companies have a healthy order book of 2.5 times FY11 revenues which provides good revenue visibility and interest rates are expected to peak in the near term.

Further, the long-term growth potential for companies in this sector cannot be ignored, given the large-scale infrastructure spending expected over the next five years.

Mr Prasad Koparkar, Head – Industry and Customised Research, Crisil Research, said, “The current state of infrastructure is increasingly becoming a bottleneck to the ambitious nine per cent plus GDP growth target. Hence, spending on infrastructure is imminent. We expect construction investments to grow at a CAGR of 13 per cent to Rs 14.8 trillion over FY12-16.”

Mr Tarun Bhatia, Director – Capital Markets, Crisil Research, said, “We believe that valuations will improve over the next 12 months as some of the concerns such as execution hurdles and interest rate are expected to fade out by the year-end, resulting in moderate earnings growth.”