Opinion Cheap at the price?
Expensive? Under-valued? How to read the stockmarkets response to the Union Budget
Is the Indian stock market expensive? Typically,how expensive or cheap a market is,is measured by a ratio called the price-earnings multiple,or P/E. One cant really take the absolute value of the benchmark index,as an indication of its value: indeed the market could be cheap when the Sensex is at 18,000,and expensive when its at 16,000. Thats because its not just the P/E alone that gives us an idea of whether a market is overvalued or undervalued,the multiple is read in context with expected corporate profits,typically for the 12-month period ahead.
At 16,300 today,the Sensex,which is an index comprising 30 stocks,and is a kind of a proxy for the Indian market,is trading at a P/E multiple of around 15.5,which is slightly higher than the long-term average of 15. The P/E multiple is derived by dividing the value of the Sensex (16,300 right now) by the expected earnings per share (eps) for its constituents which,for the coming 12 months has been estimated by analysts at Rs 1,050. Thats called a forward P/E because it takes into account future profits of companies that are yet to come in.
One could also look at what is called a trailing P/E,which would take into account profits that have already been reported; but by and large,the market prefers to look ahead. Given this,a multiple of 15.5 times doesnt seem overly expensive,given that Indian companies are expected to grow their profits by about 20 per cent in 2010-11. About six months down the line,corporate earnings for 2011-12 will come into play; as of now,estimates floating around suggest that the eps for the Sensex could be close to Rs 1,300,a smart jump of 24 per cent over 2011-12. So,if one agrees that the Indian market deserves to trade at a multiple of 15 times,that should push up the market to levels close to 20,000 (15×1300). Looking at it another way,at 16,300,the Sensex trades at just 12.5 times estimated 2011-12 earnings (16300/1300) making the market seem attractively priced.
Of course,the quality of earnings also matters. While earnings may be growing by 20 per cent,for 2010-11,they are skewed by profits of energy and metals firms; and,should anything go wrong in either of these spaces,it would upset the applecart. A strong macro-economic environment and a stable government are always preconditions for good growth in corporate earnings. Very rarely has the Indian market traded over a multiple of 16 times for a sustained period; somehow there seems to be a strong resistance at that level. Last year,the market was re-rated after the results of the general elections were announced on May 16,2009. Foreign investors were convinced that a stable government at the Centre led by the Congress Party and without any representation from the Left would deliver. They believed that even if reforms took their time coming,they would eventually happen and India would be one of the fastest growing economies in the world. Money poured in over $15 billion flowed in between mid-May and December 2009,with the added promise of a quick recovery in the home market. So at levels of 17,000,the market was trading at over 16 times forward and at a fair premium to the long-term average.
Compared to its regional peers,India today is more expensive. Taiwan,for instance,trades just under 13 times,Korea at 9 times and Malaysia at 13.5 times forward 12-month earnings. Theres good reason for that; India should be the second-fastest growing economy in the world after China. We have political stability,a fairly good legal system,a big home market and we are a young,earning nation with almost half the population less than 25.
But,while the India story looks good over the longer term,a large government borrowing programme in 2010-11 could result in an excess supply of government paper which could mean fewer borrowing options for the corporate sector.
Also,large borrowings could push up interest rates quite significantly and higher interest rates mean that both corporates and individuals will be less inclined to borrow. For the economy to grow,companies need to invest in new manufacturing capacity while individuals need to buy homes,cars and two-wheelers. Unless that happens companies will not be able to grow their profits and earnings forecasts will remain just that. That could lead to de-rating of the market P/E multiple; because,typically,there is an inverse relationship between interest rates and P/Es.
P/Es are a function of risk appetite: the higher the risk appetite the higher the P/E. When money is tight and interest rates are high,people tend to be risk averse,so P/Es drop. So,if Finance Minister Pranab Mukherjee isnt able to contain borrowings adequately in the Union Budget,the market could see a bit of a correction.
The writer is resident editor,The Financial Express,Mumbai
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