Rout on Dalal Street: Valuations come down, but still not in comfort zone

The recent rout on Dalal Street has resulted in a sharp drop in the valuation of the broader market and benchmark indices. The Sensex is now priced at 22.8 times its underlying earnings per share (EPS) in the trailing 12-months —the lowest in nearly two years.

Just five months ago in November, 2019, the index was trading 28.4 times its trailing earnings. The index's valuation peaked in May last year, when it was trading at nearly 29 times its underlying trailing earnings.

The current market correction is, however, the sharpest since the second half of 2015, when the index’s price-to-earnings multiple (P/E) had contracted by nearly a quarter in the six-month period between July, 2015 and February, 2016. At the time, the valuation had contracted by nearly 550 basis points (bps) from 22.4 times at the end of July, 2015, to 16.9 times by the end of February, 2016.

In the current episode, the valuation is down 560 bps, or around 20 per cent from the peak of November, 2019. One bps is one-hundredth of a per cent.

This, analysts say, makes the Sensex relatively cheaper, but when compared to its valuation, it is still far from a ‘screaming buy’. An asset becomes a value-buy, when its valuation becomes lower than its long-term average.

"Many stocks in the broader market, including large-cap stocks, are now trading at a very low valuation, but the benchmark indices are still relatively expensive, thanks to the high weightage of richly-valued leaders in sectors such as FMCG, retail banking, non-bank retail lenders, telecom, and cement," says G Chokklingam, founder & MD of Equinomics Research & Advisory Services.

The broader market remains expensive on a historical basis. The Sensex 10-year median price-to-earnings multiple is around 20.4 times, nearly 10 per cent lower than the index's current valuation.

A rich valuation of leaders may put further pressure on benchmark indices, but there may be price stability in beaten down but operationally and financially sound firms in sectors such as power & gas utilities, public sector banks, pharma companies, and IT services exporters.

Investors should also note that market correction has accounted for only half of the decline in the index's P/E multiple. The other half was contributed by gains from cuts in corporation tax in August, 2019, which lead to a one-time rise in corporate earnings after tax. The Sensex's underlying earnings per share shot-up by 10 per cent during the September, 2019 quarter over the April-June 2019 quarter, leading to a corresponding fall in the index's P/E multiple.

"Most of the gains from cuts in corporation tax accrued to leaders in sectors such as FMCG, retail lenders, paints, cement, and oil & gas. The gains will taper off in the second quarter of FY21, putting pressure in their valuation unless demand growth picks up by then," adds Chokkalingam.

This will hang over the broader market, unless investors get clarity about India's growth trajectory.  

Analysts, however, say that the Indian equity market and corporate earnings get a boost from low oil prices in the form of a lower import bill and higher margins as raw material prices, including metals & chemicals, are linked to oil prices directly or indirectly.

The last time when there was a major plunge in oil prices in 2015, Indian companies, especially in the manufacturing sector, reported a sharp uptick in margins, which lead to a double-digit growth in net profits in 2016, resulting in higher share prices.