Market is close to over valued territory

Is the Indian stock market fairly valued? The answer depends on who is asking the question. Valuation cannot be seen in isolation. It is relative to prevailing interest rates and returns available from other assets. Those can differ between investor classes.

Several rule of thumb valuation methods are in common use. These are all blunt instruments that ignore nuances such as policy or political risks. Let's look at one key valuation metric applied to the 50-share Nifty. The Nifty weights its 50 component stocks in proportion to their respective free float market capitalisation.

The trailing PE is at 20.83 taking the last four quarters EPS of component stocks, weighted in the same free-float proportion. Some more data is required for comparisons. The current yield on a one-year Treasury Bill is 8.25 per cent. The projected EPS growth rate of the Nifty through FY15 is 15-20 per cent, depending on who you talk to.

There are multiple ways to look at a given PE ratio. One method is to compare the earnings yield to interest rates. At a PE of 21, the earnings yield is at 4.76 per cent. This is well below the Indian T-Bill yield and therefore, suggests the Nifty is overvalued.  The T-Bill yield is a benchmark for risk-free return only with domestic institutional investors. It's too cumbersome for the retail Indian investor, who is however receiving one-year fixed-deposit returns at 8.75-9 per cent.

The rupee T-Bill yield is also not risk-free for a foreign institutional investor (FII), who faces currency risk. An FII may instead benchmark risk-free return to a US T-Bill, which has a much lower yield of 2.5 per cent. The FIIs could consider the Nifty under-valued – it depends on their assessment of the currency risk.

Another way of seeing PE is through the lens of expected growth, dividing PE by the EPS growth rate. This PEG ratio ranges between 1 and 1.3, dividing by the range of 15-20 per cent expected EPS growth. This is generally over-valuation. Ideally, the PEG should be well below one. At a PEG of over one, you are hoping for an unexpected acceleration in EPS growth.

Another method is to compare current PE to average valuations over the long-term. The logic is that valuations are generally mean-reverting unless there are large changes at the macro-economic level. The frequency distribution of the data fits closely to a bell-curve of normal distribution.

The Nifty has a 15-year mean value of 18.4 with a five-year mean value of 19.5. The median PE is 18.3 over 15 years and 19 for the past five years. The standard deviation is 3.4 for the whole period and 2.6 since 2009. About 65 per cent of all PE values fall within the first standard deviation (14.9-21.8).

Only 0.6 per cent of values fall outside the second standard deviation (11.5-29.9). This is more “centralised” than a classic normal distribution where five per cent of values are outside second standard deviation.

The current value at 20.8 is higher than average but within the first standard deviation. This suggests the Nifty is mildly over-valued, or at the higher end of fair value range.

Summing up, the Nifty seems to be overvalued, or on the edge of overvaluation, using different methods of looking at PE. The current valuations would be justified if growth accelerated substantially or rupee interest rates dropped sharply.

The former may occur on a macro-economic rebound. Interest rates would not hit desired levels until mid-2016, assuming the RBI cut policy rates through 2015. An FII may see things differently however. This could explain the difference in attitude between FIIs, who are net buyers, while domestic investors are net sellers.

The author is a technical and equity analyst