Mutual Funds

Take three-year view for valuing stocks

Mahesh Patil | Updated on June 28, 2020 Published on June 28, 2020

Soft interest rates and companies redrawing business strategies support valuations

Markets do not like uncertainty. And the uncertainty over the Covid-19 spread led to a sharp rise in volatility globally as well as in India. From the recent peak (February 19, 2020), US equity markets corrected around 35 per cent.

But they rebounded quickly, thanks to strong fiscal and monetary stimulus, gradual re-opening of the economy and expectations of a V-shaped recovery.

The S&P 500 is only 8 per cent below its all-time high now and is trading at a one-year forward PE (price-earnings) multiple of 21x which is at a 20-year high. India has underperformed global markets in the past few months.

The large-cap Nifty 50 index saw a correction of around 40 per cent from its recent peak of 12,350, but has seen a partial bounce-back to levels of 10,400.

The mid-cap index is at a five-year low while the small-cap index is at five-year low.

Given the volatility in the market and the uncertainty, how should stocks be valued and are stock valuations still attractive?

In the current environment, instead of a short-term one-year view, it would be best to take a three-year view as the economy would have normalised by then. Looking at earnings over the next one year can be misleading as the economy is going through a downturn.

PE, PB, M-cap-to-GDP

Also, one should consider multiple valuation metrics such as PE, PB (price-to-book)and market-cap-to-GDP ratio.

Earnings in India have been depressed for the past four years due to various factors such as demonetisation, NPAs in the banking sector, the NBFC crisis and Covid-19. On a depressed earnings base, the bounce-back can be decent and earnings for many sectors are likely to recover. However, this is not captured in the one-year forward multiple. Hence, PE multiples may look expensive on a one-year forward basis.

Hence, it would be preferable to use a trailing PE multiple rather than a forward multiple.

Also, since many companies have negative earnings and cannot be included in the PE based valuation, only companies whose trailing EPS (earnings per share) is positive should be considered.

The PB multiple looks at the long-term value of a company and is not significantly impacted by short-term earnings movements. So, one can use the trailing PB ratio. We can also consider the m-cap-to-GDP ratio.

Whereas earnings only give one snapshot, the m-cap-to-GDP ratio is more structural in nature. Earnings have been lagging GDP growth for the past few years and there can be mean reversion which can lead to an increase in market-cap.

If we look at the next three-year time-frame, Nifty earnings are expected to contract in FY20 and FY21 but see a strong recovery in FY22 and stabilise in FY23.

So, for a three-year valuation, we will assume a CAGR of 8 per cent for Nifty earnings from FY19A to FY22E, which is in line with the earnings CAGR over the past five years, and a stable 12 per cent in FY23E. Applying the long-term average P/EPS+ multiple of 19.2x on FY23E earnings gives us a return CAGR of 15 per cent from current levels.

The Nifty FY23E book value is just the sum of the FY20E book value and the earnings over FY21-23E less expected dividend payouts. Applying the long-term average PB multiple of 2.8x on the Nifty FY23E book value gives us a return CAGR of 15 per cent from current levels.

Taking this into consideration, we get a three-year upside return CAGR of 15 per cent for the Nifty.

The m-cap-to-GDP currently is at 65 per cent vs its 15-year average of 79 per cent, and indicates that the market has sufficient room to rise from current levels.

On the downside, there can be a correction if we don’t see signs of the Covid-19 curve in India flattening. However, markets have likely bottomed out, and one can expect a 10 per cent correction in a base-case scenario. The risk-reward is still favourable for long-term investors although markets can be volatile in the near term.

Favourable factors

It is worth noting that in the current environment, companies are re-designing their business processes to take advantage of technology, remove inefficiencies, and reduce costs. Hence, earnings growth can improve faster than expected and potentially surprise on the positive side. This has also been evident in the past wherein earnings growth has been strong after previous crises as companies focussed on reducing costs and managing their working capital.

Also, we need to bear in mind that central banks worldwide, including the RBI, are expected to maintain an accommodative stance and interest rates are expected to remain low for the next few years.

In an environment of depressed interest rates, cost of capital will remain low. That will justify relatively high valuation.

Global macro factors such as low oil prices, stable currency, high forex reserves and strong FDI (foreign direct investment)and FPI (foreign portfolio investment) flows are also in India’s favour currently. Liquidity is expected to remain high.

The above factors should also support equity valuations and it is possible that the Nifty may see a breakout to earlier highs by next year. In case of mid-cap and small-caps, valuation is difficult to look at as earnings can be volatile.

However, one can look at relative valuation vs large-caps.

In that context, they are at multi-year lows and the risk-reward, especially for small-caps, is attractive.

The writer is Co-CIO, Aditya Birla Sun Life AMC

Published on June 28, 2020
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