Mumbai: Dalal Street seems to be marching at a faster pace than the earnings growth of Indian companies.
A Mint analysis of the companies that make up India’s benchmark market index, Sensex, shows that while the market capitalization of the Sensex companies rose at a compounded annual growth rate (CAGR) of 43.4% in the four-year period 2003-07, net profit of these companies (adjusted for extraordinary income and expenses) rose by only 25.9%. (See graphic)
Simply put, share prices have gone up by more than warranted by growth in earnings.
The Sensex is an index of 30 companies, but the study is based on the performance of 22 companies that have been in the index between April 2003 and March 2007.
The Sensex was at 3,080.95 on 1 April, 2003. From there, it moved to 13,072.10 on 31 March 2007, rising more than 324% in four years.
However, in 2006-07, the growth in market capitalization of these companies, at 12%, is lower than the rise of their adjusted net profit at 30.8%. Also, only eight of the 22 companies recorded an increase in market capitalization in the last financial year, although earnings rose for all except one.
Analysts interpret this as high valuations finally forcing share prices to fall in line with underlying earnings. The growth in market capitalization for the 22 companies was much higher than earnings in both 2003-04 and 2005-06.
Raamdeo Agrawal, joint managing director at Motilal Oswal Financial Services, a domestic brokerage, says that the trend of share prices lagging earnings growth could continue in the current financial year too. He reasons that concerns about interest rates still persist; a number of companies are losing tax and deprecation benefits and, a high base effect is slowly kicking in.
Sanjay Sinha, chief investment officer at SBI Mutual Fund, says the markets typically factor in one-year forward earnings, which means that a company’s share price takes into account its next year’s earnings.
The lacklustre market performance in 2006-07 in that case would be in anticipation of a drop in growth in earnings this year (2007-08). To be sure, earnings growth of the Sensex companies is expected to fall to about 20% this financial year, from more than 30% in 2006-07.
Analysts have been warning that one of the main reasons for the 371% rise in the Sensex since the commencement of the bull run in April 2003 was a rerating of the Indian market. The Sensex’s price-earnings ratio rose by more than 50% to 20.3 times during this period.
Morgan Stanley, for example, has said that all of the Indian market’s relative outperformance compared to other emerging markets since 2003 was on account of an expansion of its price-earnings (P-E) ratio relative to its peers.
That means that this kind of P-E expansion is not sustainable and that the Indian market will, in future, rise at a more sedate pace, in line with the growth in earnings.
In recent months, the Sensex’s P-E ratio has come down to 20.85 on a trailing 12-month basis, 10% lower compared with mid-January when it was 23.25.
Not all experts think that this trend will continue.
Sandip Sabharwal, chief investment officer at JM Financial Mutual Fund, points out that the relatively subdued market performance in 2006-07 was because investors turned sceptical on account of inflation and interest rate fears.
He expects growth in market capitalization to overtake the expected 20% increase in Sensex earnings this year.
The Sensex has risen by 11% thus far this financial year.