Sensex valuation falls to nearly 5-year low with exception of Mar-Jun 2020

The valuation of the Sensex has declined to its lowest level in nearly five years with the exception of March-June 2020. The benchmark index is trading at a trailing P/E (price/earnings) of 22.74X, down from nearly 31.3X at end of May 2021 and a five-year average P/E multiple of 26X.

Analysts say the “low valuation” explains the resilience in the broader market despite a challenging domestic and global macroeconomic environment.

“Stock valuations are reasonable and lower than what we have seen in the past four years. This has attracted value buyers, especially domestic investors, and explains the current stability in the market,” said Shailendra Kumar, chief investment officer, Narnolia Securities.

According to him, the market looks even cheaper if one takes into account an expected 15 per cent growth rate in the index EPS (earnings per share) in FY23 over FY22.

The Sensex is up 5.5 per cent, or 2,881 points, from its recent low of 52,793 on May 13.

In comparison, it declined by 13 per cent, or 7,818 points, between April 4 and May 13 due to investors’ concern about rising high inflation and rising interest rates. The sharp decline in Sensex valuation largely has been due to an unprecedented jump in the index underlying EPS.

The Sensex is up 7.2 per cent since the end of May last year but the index underlying EPS is up nearly 48 per cent during the period. The index closed with a trailing EPS of Rs 2,448 on Monday, up from Rs 1,658 at the end of May 2021.

The index EPS tracks the combined earnings of the 30 companies that are part of the Sensex.

While the index has become inexpensive compared to its valuation in recent years, it remains expensive when compared to its long-term valuations. For example, in the past 20 years, the index median P/E multiple has been around 19.8 per cent, nearly 10 per cent lower than its current valuation (see the adjoining chart).

“It’s best to compare current valuation with that in the pre-2013 period. In that era, the long-term average P/E for the Sensex was around 18X and the market largely moved in the range of 15-18X. This hints at more downside risks for the market from current levels,” said Dhananjay Sinha, managing director and chief strategist, JM Institutional Equity.

He says equity valuation was greatly distorted in the past seven-eight years owing to factors such as record low interest rates, quantitative easing by central banks, and earnings volatility caused by the pandemic.

The recent bounce-back in the markets suggests equity investors are not worried about any potential downside risks to India’s economic growth or corporate earnings from higher inflation and rising interest rates.

Analysts say the Indian markets face downside risks from lower than expected corporate earnings in FY23.

“Corporate earnings and India’s economic growth continue to face downward risks from crude oil prices, which are back to $120 per barrel, and a further rate hike by the US Federal Reserve and its adverse impact on the rupee exchange rate and capital inflows into the country,” said G Chokkalingam, founder and managing director, Equinomics Research & Advisory Services.

Corporate earnings in FY23 face risks from a potential earnings contraction in sectors such as metals and mining, and banks due to factors such declines in prices, a rise in operating costs, higher interest rates, and lower demand growth.

Top companies in these sectors such as Tata Steel, JSW Steel, Hindalco, Vedanta, State Bank of India, ICICI Bank, and Axis Bank accounted for a large part of the incremental earnings growth in FY22. Any potential decline in earnings in these sectors will not only bring down the index EPS but also make the market expensive.