Markets
Stock valuations may face a reality check in the year ahead
Summary
- Rising corporate profits among larger companies and a flush of liquidity drove Indian stocks to new highs and stoked interest in IPOs in 2021. With signs of liquidity easing, 2022 is likely to see greater focus on earnings in assessing valuations.
During a pandemic where lives and livelihoods have been lost, where the economy has endured shocks of considerable sweep and scale, the most popular Indian stock index has doubled in value. Two factors underpin this seemingly counterintuitive rise: rising corporate profits, and a constant flush of capital chasing returns, including from new investors taking to the market in significant numbers.
Drowned out in this euphoria is the notion of value. A company’s stock represents the intrinsic value of its future business performance. Are India’s stocks truly worth what investors are paying for them? It’s a question that is likely to be asked more and more in 2022.
A key player in all this is the central bank of the US, the world’s largest economy. During the pandemic, to oil its wheels of growth, it has been pushing liquidity into the system. Now, it is ready to temper those flows. This is likely to impact liquidity levels, especially in emerging markets like India. As liquidity eases, investors will get more discerning.
One measure of value is the price-to-earnings (PE) ratio of a benchmark index like the 30-share BSE Sensex. This indicates the number of times the earnings of the 30 companies that make it are currently valued. A high PE ratio can either mean expectations of superior earnings growth, or overvaluation. At this point, India is one of the most richly-priced markets. And the PE ratio of the Sensex this year has touched its highest levels of the last two decades.
Great Expectations
In the past two decades, the PE ratio of BSE Sensex has commonly hovered in the 15-20 band. Above these levels, the underlying expectation is of strong and continuous earning increases. Each time that happens, it lowers the Sensex PE to saner levels. For example, a 30% increase in earnings from current levels will lower the Sensex PE from 27 to 20, whereas a 10% increase will reduce it to 25.
There is some basis to such expectations of superior earnings growth. A Mint analysis of 1,130 company results in pandemic-hit 2020-21 showed that even as their aggregate revenues fell 6%, their operating profit rose 30% and net profit surged 48%. Within this set, it was the larger companies that fared better. Yet, it’s not just the Sensex—representing the cream of listed Indian companies—that has given strong returns. Even indices representing companies in the second and third tiers have appreciated well, buoyed by liquidity. But if liquidity shrinks, it will accentuate the focus on earnings and valuations.
First-Time Investors
A spurt of liquidity has come from new individual investors. They are young and not averse to risk. One measure of new investor interest is the number of new dematerialized accounts opened. In calendar years 2018 and 2019, the monthly average was 0.3 million accounts. In 2020, this trebled to 0.9 million. In 2021, the monthly average stands at 2.4 million. These new investors have not seen a market downturn.
They entered a market that was riding on momentum, liquidity and stories. One story this year has been companies selling shares to the public for the first time. The number of such companies in 2021 is the highest since 2007, a possible sign of promoters and investors cashing in when the going is good.
Among them, for the first time, are internet businesses that offer the promise of supernormal growth. So far, they have been about listing returns, with liquidity playing a key role. Increasingly, in time, they will be valued on growth and profits.
Internet Dynamics
Most internet businesses are capital-guzzling and loss-making. This makes valuing them tricky, more so at the rich valuations they currently command. The four internet businesses to list this year have valuations that give them a multiple of 33-49 times on their 2020-21 revenues. The same market gives a revenue multiple of 3-7 times to the likes of Reliance Industries, TCS, HDFC Bank and Infosys—large, established companies growing at a steady clip year after year.
Like the PE ratio, a high revenue multiple by itself is not bad. Embedded in that is the expectation that the company will grow in size at an above-average rate for many years to come. That is something Nykaa and Policybazaar have done in the last two years, but Paytm hasn’t.
More internet businesses are looking to go public. In an environment of high liquidity, a reality check on value took a secondary seat. As liquidity pulls back, expect more questions around value to be asked in the new year.
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