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The Sensex has scaled new heights on the eve of the earnings season but, if the brokerages are to be believed, corporate results are unlikely to be very strong.

Merrill Lynch and Co.’s results preview for the December quarter says earnings growth will be the lowest in the last eight quarters. The brokerage estimates growth of 17.5% in net profits for the Sensex companies. For non-financial companies in the Sensex, profit growth is estimated to be lower, at 16.4%. Moreover, these results will be skewed because of the inclusion of DLF Ltd, which had a very low base in the year-ago period. If DLF is excluded, Merrill Lynch expects the other Sensex companies to have a net profit growth of just 14.3%.

Motilal Oswal Securities Ltd arrives at more or less the same conclusions, with profits after tax for the Sensex companies estimated to grow at 14.4%. The brokerage points out that earnings growth for the Sensex companies has been steadily declining from a peak of 43.4% in the third quarter of FY07. For each subsequent quarter, the year-on-year (y-o-y) growth rates have been 33.1% in Q4, FY07; 27.4% in the first quarter of the current fiscal year; 22.9% in the second quarter and now the prediction of 14.4% for the December quarter.

Predictions vary for the broader market, depending on the stocks that brokerages have in their portfolio. For example, Motilal Oswal estimates that profit growth for its universe of 142 companies will be 11%, once again the lowest in the last eight quarters. Ditto for the 111 companies covered by brokerage Prabhudas Lilladher. Religare is more optimistic and the companies covered by it are forecast to have earnings growth of 16% y-o-y before interest, depreciation and tax. The brokerage believes, however, that earnings growth for the companies in its universe will be 27%, thanks to higher “other income" in the oil and gas sector and lower provisioning in the banking sector. Of course, growth will be very different for different sectors. Analysts believe earnings will be dragged down by a decline in earnings for metal companies, while the performance of oil and gas companies and autos will be flat. Telecom, capital goods, real estate and consumer goods will deliver better results. The heart of the matter is that the Sensex, which used to quote at a price-earnings (P-E) multiple of 22 in January last year, now trades at a P-E of around 29, in spite of a steadily worsening earnings outlook. With earnings growth for fiscal 2009 estimated to be 18-20%, that implies a P-E to growth ratio, or PEG ratio, of well above 1.

How are analysts justifying the high valuations?

“Embedded value" is one reason. The argument is a simple one: Several of the assets that companies are sitting on are currently not earning a return, so valuations must be adjusted upwards for these assets. Insurance subsidiaries and land banks are obvious examples. Estimates of how much value should be assigned to these “embedded assets" vary widely, but research by Kotak Securities Ltd says they account for around 17% of the value of the Sensex. The trouble is, as the report points out, that the estimate of “embedded value" has risen 220% since September 2006. It says bullish market conditions are responsible for an exaggerated valuation of these assets in many cases. Execution risks in power sector stocks, for instance, have been completely ignored.

Yet, another argument points out that there have been dire warnings of an earnings slowdown for quite some time now, but earnings have consistently surprised on the upside. For instance, Citigroup Inc. had initially estimated earnings growth of 15% for FY08 and 12.4% for FY09 for the Sensex companies. But the September quarter led to a round of upward revisions. Together with the inclusion of DLF instead of Dr Reddy’s Laboratories Ltd in the Sensex and the effect of mergers and acquisitions, earnings growth has since been revised upwards to 33% for FY08 and 19% for FY09. Similarly, Motilal Oswal had an earnings per share estimate of Rs846 for FY08 at the end of the first quarter. That has since been revised raised to Rs883.

What are the factors that can lead to further upward revisions in earnings growth? One reason could be a lowering of interest rates. With continuing rate cuts from the US Federal Reserve, there is a possibility of lower interest rates in the future in India. That will boost the interest-rate sensitive sectors such as autos. A pre-election populist Budget will also help and the expectation is that it will increase consumption. Even the Sixth Pay Commission, which is supposed to submit its recommendations by April this year, is being touted as a positive thing, because brokerages are looking at the increase it will provide to consumption.

In the final analysis, it all depends on liquidity. Most market strategists are betting on continuing foreign institutional investor flows to India, which, together with private equity flows and higher domestic funds flow into the equity markets, will more than offset the long queue of initial public offers. But here’s a worrying piece of data: Reuters estimates put earnings growth for the Standard and Poor’s 500 at 15.7% for 2008, after a mere 2.8% growth in 2007. India’s earnings growth would be around 4 percentage points higher, while our P-E multiple is much higher. The continuation of strong fund flows to India may well depend on those embedded valuations, a stronger rupee and downward revisions in US earnings.

Mint’s resident market expert Manas Chakravarty looks at trends and issues related to investing in general and Indian bourses in particular. Your comments are welcome at capitalaccount@livemint.com

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