The Big Story . Is market valuation flashing red ?

The sentiment in the Indian equity market was quite sombre towards the beginning of 2019, with weak earnings outlook as well as governance concerns in India Inc, monetary policy tightening by central banks, and a global trade war casting a pall of gloom on stocks. But three months later, there is cheer all around. The Sensex and the Nifty have gained 8 per cent since the beginning of 2019 and are hitting record highs. The principle trigger for the change in sentiment was the enhanced expectation of the current NDA government regaining power at the Centre.

The ongoing market rally has, however, been making alarm bells ring because it is not entirely backed by fundamentals, and seems to be driven by foreign portfolio flows. India Inc has been bringing out woeful earnings numbers over the past five years ,with the average annual growth in the net profit of stocks in the BSE 500 being -0.41 per cent between 2014 and 2018. The first nine months of FY19 were worse, with profit declining 7.3 per cent compared with the same period in FY18. A rally accompanied by stuttering profitability has resulted in the price-earnings multiples of the Sensex and the Nifty surpassing the levels recorded in 2007.

The PE multiples seem to imply that equity prices have reached a peak, and a crash is overdue. But is this assumption right?

We delve into the Sensex’s price earnings numbers and other valuation metrics to get some answers.

The PE puzzle

The most popular ratio used to judge if an index or a stock is under- or over-valued is the Price Earnings multiple — the PE ratio — which is computed by dividing the market price of the security by the earnings per share. This ratio moors the stock price to its fundamentals and can easily flag periods of under- or over-valuation.

According to Bloomberg, the PE multiple of the Sensex, based on its trailing 12-month consolidated earnings, is currently 29.5. This has raised concerns because a) this number is far higher than the historical average, and b) it makes the Indian benchmark the most expensive, globally.

The Sensex was not always accorded such exalted PE multiples. For instance, between 2011 and 2014, the average multiple at which the index traded was 17. In November 2008, the Sensex traded at a PE multiple of 9 times. The PE multiple in December 2007, before the subprime crisis-led crash, was just 24.6 times.

The PE multiples at which other global benchmarks currently trade at are also much lower. The S&P 500 index, which represents the US market that has been racing high of late, sports a PE of 19.1. The FTSE 100 index of the UK trades at 17.5, while Germany’s DAX trades at 15.3. Benchmarks of emerging economies such as China, Korea, Indonesia and Brazil also trade at PE multiples between 11 and 20 times.

Does this mean that the Indian equity market is due for a steep correction? No.

A new normal

A structural change appears to have taken place since 2017 in the price-to-earnings multiples of large-cap indices such as the Sensex.

This is indicated by the analysis of the premium/discount of the Sensex’s PE over the PE multiples of other global benchmarks since 2009. Between 2009 and 2016, the Sensex had not always trade at a premium to its peers. There were many periods when the PE of the Sensex was lower than the multiples of other indices. But this seems to have changed from 2017, with the premium of the Sensex expanding sharply against all other global indices. This premium has widened further in 2019.

For instance, the Sensex’s PE had traded at an average discount of 12.1 per cent to the PE of Jakarta Composite Index between 2009 and 2016. This changed to a premium of 18 per cent from 2017. A similar change is visible while comparing with other indices, too. The monthly average premium of the PE multiple of the Sensex over the PE of the S&P 500 between 2009 and 2016 was 10 per cent. This widened to 21 per cent from 2017; it has further widened to 55 per cent in 2019.

An analysis of the three-year moving average of the PE multiple of the Sensex also shows that there has been a steep adjustment in this metric since 2017. The three-year moving average PE multiple of the Sensex ranged 17-19.5 from 2007 until mid-2017. It crossed 20 in 2017, and has been steadily inching higher since then to currently stand at 22.9. A new normal in the PE multiple of the benchmark index seems to have been formed.

So, what has caused this structural shift? It was the money laundered during the demonetisation drive — which found its way into the Indian stock market through the mutual fund route — that seems to have upset the equilibrium in the Sensex’s PE valuation. MFs net purchased ₹1,17,675 crore in the Indian equity market in 2017, much higher than the average purchase of ₹47,077 crore in the preceding three years. These MF flows were largely concentrated in few of the large-cap stocks due to Indian investors’ risk-averse attitude, expanding the Sensex’s PE. (The Sensex is formed by 30 of the largest stocks by market cap in the Indian market.)

Due to the inflows, the Sensex was among the best-performing global indices in 2017 with 28 per cent gains. Other indices, too, fared well, but returned lower than the Sensex. But the Indian benchmark followed this stellar performance with another 6 per cent gain in 2018, even as its peers recorded sharp losses on trade-war fears, geo-political tensions, etc. This further expanded the premium of the Sensex PE over its peers. And the Sensex’s rally continues in 2019, sustaining this premium.

The other factor that exacerbated the PE multiple was the poor show by the Sensex constituents in FY19. While the companies in the index grew their earnings by 12 per cent in FY17 and FY18, the earnings de-grew 7 per cent in the first three quarters of FY19 compared with the corresponding period in FY18. The weak earnings numbers in the December quarter of FY19 made the PE multiple of the Sensex jump to 27 in January 2019, from 24 in December 2018. The rally since March this year has further exacerbated the metric.

Cause for concern?

But there are many reasons why investors need not fret over the Sensex PE. One, as explained above, the PE bands for the Sensex and the Nifty could have shifted to a new normal, due to the deluge of money received in 2017. With retail investors taking to MFs in a big way, flows through the SIP route into MFs is likely to continue, supporting the market in corrections, keeping the PE elevated.

Two, the earnings of the Sensex constituents could improve going forward, helping cool the PE. The unusually weak show by the Sensex constituents in FY19 was due to the sharp loss recorded by Tata Motors, due to writing down of certain product development costs and tangible assets at Jaguar Land Rover (JLR); provisioning for NPAs by banks; and a few one-off hits in other companies. If the loss recorded by Tata Motors is excluded, Sensex’s earnings grew 8 per cent in the first nine months of 2019. With provisioning by banks likely to moderate in the coming quarters and Tata Motors trying to mitigate the problems at JLR through cost-cutting and an improved product-mix, Sensex’s EPS (earnings per share) could look optically better going ahead.

Three, if we compare the current PE of the Sensex components with their three-year average PE multiples, there isn’ttoo much over-valuation in individual companies. Barring a few stock such as Bharti Airtel, RIL and private banks, most stocks are trading around, or below, their three-year average price-earnings multiples. Thirteen of the 30 Sensex stocks are trading at a discount to their three-year average PEs.

Four, there is a vast investable universe beyond the Sensex 30 stocks. Correction in mid- and small-cap stocks in 2018 has now made them much better-valued. It is possible to find value buys in the broader market.

Five, other indicators that are used to gauge the valuation of the broader market are not flashing red yet.

Price-to-book value

Another way to evaluate if the Indian market is rightly priced or not is by using the Price-to-Book Value (PBV) ratio. This ratio is derived by dividing the market value by the book value. The book value per share is derived by deducting the liabilities from the assets of a company.

According to Bloomberg, the PBV ratio of the Sensex was 2.9 towards the end of 2018, and is estimated to decline to 2.82 by 2019-end. This ratio hit a recent peak of 3.57 towards the end of 2010, and has ranged 2.5-3 since then.

Typically, a PBV ratio under 3 is considered tolerable. A range-bound PBV ratio in the Sensex over the last eight years implies that the increase in net assets has kept pace with the increase in stock prices. The increase in net assets might have been the result of either an addition to assets or a decrease in liabilities. The book value in some sectors such as banks could also have been inflated as the NPAs were not adjusted in the calculation.

The current PBV ratio of the Sensex, at 3.06, is lower than the 6.09 hit towards the end of 2007, implying that the market is not overheated. But investors should exercise caution since the metric is near the upper-end of its long-term range.

Market cap-to-GDP ratio

The market cap-to-GDP ratio or the Buffett indicator is another ratio that is used to draw broad conclusions on the valuation of a market. But this indicator has too many flaws to make it reliable. It is derived by dividing the total market cap by the nominal GDP. If the ratio is close to 1, the market is said to be fairly valued.

GDP at a country level is equated with sales of a company; therefore, this ratio is akin to price-to-sales ratio. But applying the ratio to gauge market valuation does not appear ideal since listed stocks do not represent the GDP in its entirety. For instance, agriculture, which accounts for around 16 per cent of India’s GDP, and public administration, defence and other services that account for another 12 per cent, have scant representation in the listed stock universe.

Since the stock market does not capture all the economic activity, a ratio between 0.70 and 0.90 could signal a fair value for the market. This is in sync with empirical data, too. A reading above 0.9 represents an overheating market, and below 0.70 represents buying opportunity in the Indian market.

Towards the end of 2007, the M-cap-to-GDP ratio was 1.54 — a screaming sell. Overheating was also indicated towards the end of 2010 (1.01) and 2017 (0.91). In contrast, buying opportunity was indicated in December 2016 (0.71), 2013 (0.64) and 2011 (0.63).

By this yardstick, the current reading of 0.83 indicates that the market is fairly valued but is not cheap.

Our take

To sum up, the most popular stock market gauge, the PE ratio, appears overheated going by the headline number. But the number has been adjusted higher due to the influence of higher liquidity, causing an extended outperformance of the Indian market. Other metrics such as the PBV and market cap-to-GDP ratios signal that the market valuation is not too stretched.

That said, the expectation in the market regarding the future earnings of the Sensex appears overoptimistic. The Bloomberg consensus estimate for Sensex’s EPS for FY20 is ₹2,074, 55 per cent higher than the current EPS of ₹1,331. Analysts seem to be too upbeat about the banks’ ability to recover their NPA dues through the Insolvency and Bankruptcy Code (IBC). Similarly, other headwinds such as the impact on consumption due to liquidity crunch, high borrowing cost and below-normal monsoon, and delay in infra-order inflows around the elections have also not been accounted for.

The declining profitability of the Sensex constituents is another worry. This is aptly captured by the Sensex’s Return on Equity (ROE) ratio declining consistently since the 2007-peak of 32 per cent, to 10.9 per cent towards end-2018. The sharp decline in this metric highlights the lack of demand in the economy and companies’ unwillingness to use leverage to grow business. It is, therefore, prudent to temper one’s expectations regarding market returns from the current levels. If incessant flows continue taking stock prices higher, the indicators will start flashing red, from amber.

(With inputs from Dhuraivel Gunasekaran.)

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