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Shivendra Gupta: Markets: Blind men and the Elephant

Why do local investors stay away when foreign institutional investors are pouring money into Indian equity?


Why do local investors stay away when foreign institutional investors are pouring money into Indian equity?

Foreign Institutional Investors (FIIs) have invested over Rs 1,30,000 crore in the Indian equity markets in Samvat 2066 but Indian retail investors have largely shied away from the markets. While high top line and bottom line growth of Indian companies coupled with uncertainty in the global markets have been the main reasons for the FII flows, the lack of interest on the part of Indian investors needs to be explained.

The key question is that with access to the same underlying cash flows, how are FIIs so enthusiastic about the valuations when Indian investors are wary? This is mainly attributed to the unpleasant experience of the last two years. Economically, it can be explained through an understanding of how companies are valued.

The value of a firm is determined by discounting its future cash flows to the equity shareholders by the cost of equity. The cost of equity, in turn, is calculated as a sum of the risk-free return and the market risk premium attributed to the firm.

In today’s globalised economy, where capital flows much more freely between nations, the difference in the prevailing interest rates across countries can create a distortion in fundamental equity valuations depending on the residence of the investor.

Just to illustrate how this may make a difference, consider a series of cash flow to a firm’s equity shareholders of Rs 100 in year one, which grows at 10 per cent till the fifth year and is expected to grow at 3 per cent to perpetuity. If we discount this cash flow at a cost of equity of 13 per cent ( India’s 10-year government bond yield of 8 per cent as the risk-free rate plus an assumed 5 per cent market risk premium), the equity value of the firm is Rs 1,144 (see Table 1).

If we now replace the Indian risk-free rate of 8 per cent with, say, 2.5 per cent, which is the US 10-year government bond yield, the value of the same firm jumps to Rs 2,659. So, for a US investor the same cash flows are worth Rs 2,659 (see Table 2 for the change in the value of the firm depending on the country of residence of the investor).

Typically while investing overseas, in addition to the risk-free rate and the market premium, analysts add a “currency risk premium” while valuing overseas stocks. This essentially is the anticipated depreciation in the currency in which the underlying firm earns its revenue as against the currency of the investor. So in the above example, the valuation of the firm for the Indian Investor and the US investor would largely get equated by adding a currency risk premium for the US investor, which ideally should be equal to the difference between the risk- free rate in the US and India, which, in turn, should typically reflect the difference in inflation in the two countries.

However, in the current global environment where economies are still being pump-primed and nations are engaged in currency wars, actual currency movements have little, if no, co-relation to prevailing interest rates and inflation in the respective countries. So, in reality, the Indian rupee has actually appreciated by 0.64 per cent per year against the dollar in the last five years. See Table 3 for the five-year rupee depreciation vis a vis the currencies of some key global countries.

It is this movement in exchange rates that is making investments by FIIs in India so lucrative for them, while for Indian investors the stocks seem to be fundamentally fully valued. Ideally, there should be two different prices for the two investors. But a common market place and a common market price lead Indian investors to either sit on the sidelines or make seemingly irrational investment decisions.

But sitting on the sidelines and waiting for valuations to come to fundamental levels may also be a mistake for Indian investors since Indian values continue to remain within the fundamental zone for investors in other countries. Or maybe, there is a need for some economist to redo the valuation models to take such distortions into account while valuing stocks and add a factor on global liquidity in the formula.

Click here to see tables

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First Published: Mon, November 15 2010. 00:04 IST