Broader market valuation at all-time high even as key indices appear cheap

Valuations are steeper for foreign investors

A steady rise in market capitalisation in the past three years, coupled with stagnant corporate earnings, has pushed up the valuation of the broader market to an all-time high even as the benchmark indices like the S&P BSE Sensex and Nifty50 still look cheap compared to their previous highs.

A broader sample of large-cap, mid-cap and small-cap stocks are now trading at 30.5 times their combined net profit in the past 12 months.

This valuation is nearly 50 per cent higher than the Sensex companies’ current price-to-earnings (P/E) multiple of 30 per cent. The index companies’ valuation had peaked at the trailing P/E multiple of 28 at the end of December 2007, a week before the start of the big 2008 market correction. The broader market was valued at 22x at the end of December 2007, or about a fifth lower than the benchmark indices.

The combined market capitalisation of all listed companies is up 71 per cent in the past three years (since March 2014) against a 1.5 per cent decline in their combined net profit during the same period. In all, stock prices have doubled, on average, since the beginning of the current bull run in March 2013 against a marginal 0.6 per cent cumulative growth rate in net profit during the period.

The sample companies’ combined net profit grew from Rs 3.52 lakh crore in FY13 to Rs 3.54 lakh crore in FY17. In comparison, their combined market capitalisation jumped from Rs 53.7 lakh crore at the end of March 2013 to Rs 108.1 lakh crore at the end of market trading on July 12, 2017.

The broader market is, however, still cheap by around 50 basis points (bps) on price-to-book value, compared to the previous high in March 2008. But, this is hardly comforting, given that the return on net worth (or equity or shareholders’ funds) is now less than half at 9.3 per cent, compared to 19 per cent in FY08.

The analysis is based on a common sample of 802 companies from the BSE 500, BSE MidCap and BSE SmallCap indices. It excludes public sector oil-marketing companies and cyclicals such as Vedanta and Tata Steel, which have reported large exceptional losses in the past three years.

Including these cyclicals, the combined market capitalisation is up 99 per cent since March 2013, against 12 per cent cumulative growth in earnings during the period.

Valuations are even steeper for foreign investors who benchmark their yields in India with benchmark interest rates in the US. The earnings yield for the broader market is now down to a record low of 3.3 per cent and its spread over US treasury yields is at a record low of 0.93 percentage point. The spread was 1.9 percentage point at the end of FY16 and 4.8 percentage points at beginning of the current rally in March 2013. The spread was 1.5 percentage point at the end of March 2008.

The earnings yield is the potential yield for an equity investor if the company pays 100 per cent of its current (annual) net profit as equity dividend. Simply put, it is net profit divided by the market capitalisation of a company. Typically, the earnings yield on equities should be sufficiently higher than the yield on risk-free assets (such as government bonds) to compensate for the greater risk of owning equities.

Analysts say that this raises the prospect of an outflow of capital from the equity market if the bond yields in the US harden any further. “The market has been expensive for too long now, aided by lower interest rates in major developed markets like the US. Any further tightening of interest rates in the US or further fall in the earnings yield in India may lead to a market correction,” says Dhananjay Sinha, head research, economist and equity strategist, Emkay Global Financial Services.

The benchmark interest rates in the US are up nearly 20 bps since the beginning of the current calendar year. One basis point is one-hundredth of one per cent.

This has been partly compensated by around a decline of 10 bps in benchmark interest rates in India. While many are expecting interest rate cuts by the Reserve Bank of India, there are others who think otherwise. They argue that interest rates in India could rise, as various state governments hit the bond market to raise funds to finance the farm loan waivers and bigger fiscal deficits.

For domestic investors, the yield spread on equities (difference between 10-year G-Sec yield and equities yield) is now a negative 3.2 percentage point, which is worse than a negative spread of 2.8 percentage point at the end of March 2014 but better than negative 4 percentage point at the end of FY15.

Simply, a broad portfolio of stocks now yields a potential dividend of Rs 3,300 for every Rs 1 lakh worth of investment, down from Rs 4,000 at the end of March 2016 and Rs 6,600 at the end of March 2013.

The market is set to get even more expensive as brokerages expect companies to report declines in net profits on a year-on-year (YoY) basis during the June 2017 quarter. The combined net profit of all Nifty50 companies is expected to decline by 2.6 per cent YoY during the quarter, while excluding metals & oil companies, the net profit is likely to decline by 7.6 per cent YoY for the June quarter. Three index companies — TCS, IndusInd Bank, and Infosys — have reported their first-quarter results so far and the net profit trend is far from being exciting.

Given the current state, investment experts are advising investors to sit on cash, fearing a market correction. “Ideally, I would like investors to sit on cash, but if that not possible then they should invest in beaten-down large-cap stocks in sectors such as information technology services and pharma,” says G Chokkalingam, founder & managing director, Equinomics Research & Advisory. Chokkalingam is not alone and many others are echoing a similar view.

In an interview in Business Standard, Abhinav Khanna, head of equities at Citi India, says: “The Nifty50 index is trading at around 19x FY18E, while MSCI India is at around 18x, certainly not cheap, especially when we expect higher chances of earnings downgrades than upgrades. Mid-caps and small-caps across some sectors are more expensive than their large-cap counterparts, with the added risk of less liquidity and lower earnings visibility.”