Is the BSE Sensex really overvalued?2 min read . Updated: 15 Jun 2017, 05:00 AM IST
Although Sensex appears overvalued on conventional metrics, a long-term indicator, Shiller's scale, suggests that it may still have room to rise
Mumbai: With the Indian markets hovering near record highs, several commentators have warned about markets being over-valued. However, any such assessment is based on near-term estimates of earnings rather than an assessment of long-term trends.
One popular long-term earnings indicator, developed by the Nobel Prize-winning economist, Robert Shiller, and used globally to assess market valuations, suggests that Indian markets are not yet over-heated although they have begun heating up over the past few months.
Shiller developed this indicator known as the cyclically adjusted price-earnings multiple or CAPE in his best-selling book Irrational Exuberance, published in 2000 at the height of the dot-com bubble (which burst just after the book warned of the gross overvaluation in the market).
The logic behind the CAPE indicator is simple enough. The common trailing price-earnings multiple is susceptible to be distorted by business cycles. Earnings can be elevated in a boom and depressed in a bust, thus not presenting a true picture of market value. So, the CAPE indicator considers 10 years of inflation-adjusted earnings to smooth out the impact of business cycles.
Using Shiller’s methodology, and constructing the CAPE indicator for India, we find that the Indian market was far more overvalued in the peak of 2010 than it is now.
Nonetheless, the CAPE indicator has been climbing up steeply over the past few months, and has reached its highest level since July 2015. The calculations are based on figures till the month of April, for which the latest inflation data is available.
The traditional metric for assessing valuations, the price-earnings (PE) ratio measures how much an investor is willing to pay to own the company in relation to its profits. Consider a company which is trading at a PE of 10. This means that investors are paying Rs10 for every Re1 of the company’s earnings. The higher the multiple, the more expensive the company.
The CAPE indicator takes this traditional metric and accounts for business cycles by taking an inflation-adjusted decadal earnings average for the denominator. To calculate the CAPE values for India, the Sensex numbers have been used, after adjustments for inflation using the CPI-Industrial Worker index.
The latest reading shows that the Shiller PE is 20.13 for India’s benchmark Sensex index. Meanwhile, the trailing 12-month PE is close to 23 for the same period. This is significantly ahead of its 15-year average which is closer to 19.
The trailing 12-month PE ratio tends to look expensive during earnings slumps since the denominator is low. Hence while the market looks attractive on the basis of the long-term lens of Shiller’s CAPE indicator, it looks more expensive based on the conventional metric of the trailing PE ratio.
Unless earnings growth recovers meaningfully, this will reflect even in the long-term CAPE indicator, and the markets will run out of steam then. Till then, markets may still have some room to rise, Shiller’s scale suggests.