Is India’s equity market cheap enough for you to buy into?
6 min read.Updated: 10 Sep 2019, 10:17 PM ISTNeil Borate
Valuations can help you figure out whether the market is cheap but they don’t give the complete picture
Apart from valuations, other factors like revenue growth, earnings growth and sentiment affect returns
Each time the stock market falls over a period of time, arguments on whether or not it is now cheap enough to buy into begin. While fund managers make these arguments in interviews and presentations, brokers and analysts send out reports. This confuses the retail investor who is afraid of the market and hesitant to take the equity leap. While we maintain that regular investments are about not timing the stock market, it is important to address this “cheap market" question as well.
One way to figure out whether the stock market is really “cheap" is to look at valuations. Valuations are comparisons of stock prices to company fundamentals such as earnings, book value and dividend. A high price relative to earnings demonstrates a high valuation and vice-versa. Investing at low valuations can raise an investor’s returns from equity, particularly at a market-wide level. However, investors should note that several other factors like revenue growth, earnings growth and sentiment affect returns and valuations alone are not enough to make a decision.
In this piece, we looked at valuations displayed on the website of the National Stock Exchange of India (NSE) with respect to the benchmark Nifty index. NSE gives three important valuation measures—price-to-earnings (PE), price-to-book (PB) and dividend yield.
The first of these compares the index price to the earnings of Nifty companies, the second compares price to the book (accounting) value of these companies and the third compares the price to the dividends paid out by the companies. The current (as of 6 September 2019) PE value of the Nifty is 26.91 which is a lot higher than its 10-year average of 21.99. This denotes significant overvaluation, even after the recent correction. In addition, investors should take note of how much it is influenced by a few frontline stocks. The one-year return for the Nifty is -3.84% but much of this is influenced by the largest companies in it. The top 10 companies in the Nifty have gained about ₹1.5 trillion in market cap, while the bottom 40 lost around ₹6.20 trillion in market cap.
The second measure compares the price of a stock to its accounting or book value. The Nifty PB value at 3.32 is lower than the 10-year average of 3.36, which shows a slight undervaluation. However, PB is not an appropriate valuation measure for asset-light companies such as IT-software. Such companies do not own huge portions of land or machinery on their books but still have high earnings. On the other hand, PB is preferred over PE while analyzing banks.
The third measure, dividend yield (which is interpreted in the opposite manner), also shows undervaluation. The current dividend yield at 1.4 is higher than the 10-year average of 1.29. However, a high dividend yield may indicate that the company has run out of ideas for growth and prefers to just return cash to shareholders. A lot of government companies have high dividend yields which are a result of the government’s budgetary needs rather than a real valuation measure.
Two out of the three indicators are indicating undervaluation. Does that mean that the index is undervalued? Not quite. The divergences are not very high—they are within two standard deviations (which measures the volatility in the returns) of the 10-year average, meaning that the signals are mild at best. However, the lack of a sharp statistical signal showing undervaluation itself gives us an answer—we can rule out the argument that the Nifty 50 is highly undervalued compared to its historical averages.
Investors should consider a few more points while interpreting these numbers. First, take reports issued by brokerages with a pinch of salt. Brokers have an inherent financial interest in getting you to trade. Second, the NSE numbers are displayed on what is known as “trailing basis". In other words, they compare the current value of the index to the combined earnings of the index companies. Many other forecasters use “forward basis" which compares index values to expected or estimated earnings. One of the most popular valuation models used by financial analysts called the discounted cash flow model or DCF, looks at future cash flows and discounts them by the risk-free rate to value a company. That said the numbers are not very different for the Nifty forward valuations compared to the 10-year history. The India Valuations Handbook of Motilal Oswal Institutional Research for August 2019 noted that valuations are close to their long-term averages. It put the Nifty forward PE at 18.2, slightly above the 10-year forward PE of 18. It placed the Nifty PB at 2.5, only slightly below the 10-year Nifty PB at 2.6.
Third, these are numbers for the Nifty—the 50 largest companies in the index. The story is quite different for mid-caps and small-caps. However, the NSE does not publish a valuation history of the mid- and small-cap indices, making it difficult to replicate this study for them. The Motilal Oswal India Valuations Handbook, however, shows significant mid-cap undervaluation. It places the PE of the Nifty Midcap 100 at 14.9 compared to its 10-year average of 20.7. Navneet Munot, chief investment officer, SBI Mutual Fund, in a note on the market outlook, issued on 4 September, also noted attractive valuations in the mid- and small-cap space. But selection is equally important in this space because divergence in performance of companies is high and going merely by the segment’s undervaluation may be dangerous.
So why is the benchmark index not undervalued, even after enduring a sharp fall over the past year? The present correction has taken the one-year return of the Nifty to -3.84% (as of 6 September) and the three-year return to just 8.27%. Pankaj Murarka, founder and fund manager, Renaissance Investment Managers, in a recent article pointed to a lost decade in terms of earnings growth. According to him, Nifty earnings grew at just 7% CAGR (compounded annual growth rate) in the 2009-2019 period compared to 13% in the 1998-2008 period. It took 10 years to double the Nifty earnings per share (EPS) from ₹247 to ₹496. So why did this occur despite high GDP growth until recently? According to Murarka, corporate profits failed to keep up with GDP growth. They fell as a percentage of GDP from a high of 7.8% in FY07-08 to just 3% in FY 17-18.
Will profits recover from here? Murarka, believes so, particularly in corporate banks and pharma. Munot also noted that the corporate profit to GDP ratio had hit a multi-decade low and “mean reversion" should be in order. He also expected the earnings rebound to be led by financials. However, with GDP growth slowing to 5% at a six-year low, it is difficult to see how this will happen.
As interest rates fall and so do returns on your fixed deposits or liquid funds, your bank relationship manager may ask you to move into equities. Such pitches will typically argue that equity markets are cheap. Be careful, the signals are mixed at best. If you do wish to dip your toes more into stocks, use the systematic investment plan or systematic transfer plan route to average out your entry price.
The valuation story looks stronger in the mid- and small-cap segment but remember that it is a vast and diverse space. There are around 4,900 listed mid- and small-cap companies in India and just 100 large-caps. The fund you are being pitched may or may not capitalize on low valuations if the fund manager’s skills fall short. Remember that unless you have an asset allocation in mind, you will always be chasing last year’s winning asset class.