Rate cuts positive, but can it help sustain India's premium valuation

When interest rates fall, the fair valuation of equity rises. The easiest way to understand why is to compare earnings to interest. There are obvious differences between the two, of course. Interest is predictable. Earnings is uncertain. Interest paid is cash to the investor. Earnings are notional except for dividend (which may be zero).

The nominal face-value of a share is very rarely the same as the market price and in almost every profit making company, market price is at premium to face-value. In contrast, a debt instrument is often available at par, or discount to par (in treasury auctions). Those differences must be kept in mind. The uncertainty adds to the risk for equity but it also means earnings may grow quickly and large capital gains can occur.

Interest yields rise if there is discount to par value, or interest rates are hiked. Conversely, yields fall if the interest rate is cut. Earnings yields rise if there's an increase in profitability, or share prices fall. (Note that earning yield is the exact inverse of the price-earnings (PE) ratio.)

From the investor's point of view, the choice between instruments is dictated by perceptions of risk and the expected return on capital. Given an interest yield of x per cent, a cautious investor will want a higher earnings yield to balance the higher risk.

If interest yield rises, the earnings yield should rise. If interest yield falls, the earning yield should fall. Since the PE is the inverse of earnings yield, the PE rises when interest yield falls. This translates into higher fair valuations for equity hand-in-hand with lower interest rates.

For the past two years, stocks have traded at low earnings yields (that is, high PEs), compared to the going interest yields. A one-year fixed deposit for instance, was available at 7.5 per cent, while the 364 Treasury bill (the most risk-free of instruments) was auctioned at yields of about 7.4 per cent. A reasonable earnings yield on equity would be say, 7.5 per cent or equivalent to PE 12.3.

But the major indices like the Nifty and Sensex have traded at PEs of 21-plus for the last year to 18 months. In fact, the indices have generally traded at a long-term average of PE 19-20 over the past ten years. This is major overvaluation compared to interest yields. It can be justified only by expectations of spurts in earnings growth, and/or a sustained fall in interest rates.

In theoretical terms, a PE of 20 would be okay if interest rates moved below five per cent. This may happen if current inflation trends are sustained. The Wholesale Price Index is in negative territory and the Consumer Price Index (CPI) is below four per cent. If the Reserve Bank of India's (RBI's) inflation targets are met for January 2016 (a band of 4-6 per cent year-on-year change for the CPI in December 2015), and inflation continues to trend down, RBI might continue to cut. Then, rates could indeed fall below five per cent in calendar 2016.

RBI has just cut policy rates by 50 basis points. This is the fourth rate cut in calendar 2015, totalling 125 basis points reduction to the policy Repurchase Rate. However, as the RBI governor has repeatedly pointed out, the earlier cuts have not been fully transmitted by banks with similar cuts in commercial interest rates.

If rate cuts are fully transmitted, and RBI continues to cut rates in 2016, and earnings growth picks up as well, current valuations may be justified. This is not impossible. But, it is an optimistic scenario. Otherwise, equity will remain over-valued.

The author is a technical and equity analyst