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Business News/ Markets / Mark To Market/  Optimistic earnings estimates, frothy valuations are a recipe for disaster
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Optimistic earnings estimates, frothy valuations are a recipe for disaster

These highly optimistic earnings estimates were accompanied by frothy stock valuations, which clearly were a recipe for disaster
  • Unless there are clear signs of a demand recovery, investors must be prepared for sharp earnings cuts going forward.
  •  People walk past the Bombay Stock Exchange (BSE) building in Mumbai. (REUTERS)Premium
    People walk past the Bombay Stock Exchange (BSE) building in Mumbai. (REUTERS)

    Expectations from the March quarter results were running low, given the lockdown imposed in end-March and social distancing norms that affected many industries even before the coronavirus outbreak. Even so, the Q4 results had a silver lining in terms of improvement in operating margins, largely buoyed by cost cuts.

    Of course, cost reduction can help earnings only so far. Demand remains a big worry, although for some reason, it was not reflected adequately in earnings estimates for FY21 and FY22. Consensus estimates had built in only a 2% decline in earnings per share for Nifty stocks in FY21, and assumed 35% year-on-year growth in FY22, said HDFC Securities Ltd analysts.

    These highly optimistic earnings estimates were accompanied by frothy stock valuations, which clearly were a recipe for disaster.

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    On an aggregate level, Nifty stocks, excluding financials, are back at their peak levels in February. “Nifty (ex-financials) is back to pre-covid peak levels and overall Nifty valuations back to ~18 times FY22 price-to-earnings," HDFC Securities said in a report on 4 July. Analysts at HDFC said for six consecutive years there has been significant overestimation by the Street as far as earnings estimates go. It will be interesting if the optimistic estimates for FY21-FY22 turn out to be right at a time when uncertainty and unpredictability are far greater.

    Of course, earnings estimates are being cut after the March quarter results, but not sharply enough. For instance, Motilal Oswal Securities Ltd has cut its FY21 Nifty EPS estimates by 9% to 454 from 499 earlier. The Q4 results show that most companies are relying on cost-cutting measures to contain the drop in revenues. Many companies also benefited from low raw material costs due to weak crude prices. Of course, this was not enough to offset the impact on profits, due to the drop in volumes.

    “For the 140 companies under our coverage that have reported earnings, PAT (profit after tax) declined 55% year-on-year, with the earnings miss primarily led by industrials, private banks and oil and gas companies," JM Financial Institutional Securities Ltd analysts said in a report on 2 July.

    Evidently, analysts expected a sort of V-shaped recovery, going by the consensus estimates of flat earnings in FY21. But management commentaries, across the board, suggest there is no clarity on demand recovery. In this backdrop, companies are likely to remain focused on cost and cash preservation in FY21, to keep losses in check.

    JM Financial said, at an overall level, nearly 60% of companies it tracks mentioned taking cost reduction measures. Firms with leveraged balance sheets, especially in the utilities, cement and capital goods sectors, chose to delay capex. But, as mentioned earlier, cost cuts can help earnings only to an extent.

    Unless there are clear signs of a demand recovery, investors must be prepared for sharp earnings cuts going forward.

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    Published: 08 Jul 2020, 12:27 PM IST
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