Taking stock of market valuations

Is the stock market overheated? Should I brace myself for a correction? Such investor concerns are often addressed by drawing attention to the "market" valuations, as reflected in the current price-earnings multiple (PE) of the Sensex or the Nifty.

The current Sensex PE of about 20.5 times, may, for instance, appear quite reasonable if one considers that India Inc.'s earnings grew over 40 per cent for the just-concluded quarter.

But investors may need to treat such numbers with caution. For one, the published PE multiples of the Sensex and the Nifty indices tend to be understated, because of the method adopted for their calculation.

Second, given that so much of the market action in the Indian context, takes place outside of the index stocks, PE multiples for broader market indices such as the BSE-500 may be a better gauge of "market" valuations.

An analysis of "market valuations" after accounting for these two factors clearly shows that the price-earnings multiples have expanded sharply over the past year.

This suggests that last year's stock price gains have been driven as much by a "re-rating" of company earnings (that is, the markets' willingness to pay more for every rupee of current earnings), as by the scorching pace of earnings growth.

Restating the Sensex PE

Published PE numbers for market indices such as the Sensex or the Nifty may be understating the actual multiples enjoyed by India's frontline companies.

This is because the published PE numbers are calculated by dividing the total market capitalisation of the index by the total profits of the index constituents.

But using the aggregate numbers bestows select companies with a large earnings base, such as ONGC or Tata Steel, with a huge influence on the index valuations.

Loss-making companies in the basket (though there were none in 2006-07) may further distort the picture, as they would not have any meaningful PE, but would drag down the aggregate profits for the Sensex basket.

A re-computation of the Sensex PE multiple based on the average multiples actually enjoyed by individual stocks (using market cap to "weight" these numbers) places the Sensex PE at about 23 times trailing 12-month earnings.

A similar computation for the Nifty places its valuation at about 24 times earnings. Neither is a modest valuation.

In fact, current market valuations require the earnings of the index constituents to grow at 23-25 per cent compounded over the next five years.

PEs expand

Trends in the PE multiple over the past year also raise flags of caution. Between June 2006 and now, the Sensex PE multiple has widened from about 16 times historical earnings to over 23 times.

While stock prices of the Sensex companies appreciated by an average 48 per cent over this period, per share earnings of the companies in it expanded at an average 33 per cent.

Clearly, if stock prices gained so sharply over the past year, this is not only because companies delivered strong earnings growth, but also because investors are now willing to pay a higher price for each rupee of earnings delivered by the company. Such a "re-rating" suggests that investors are now factoring in a significant acceleration in earnings growth for companies from current levels.

A disappointment, in the form of slower earnings growth or fewer companies that are able deliver on expectations, could lead to a de-rating of valuations and a significant downside to stock prices.

Investors should also note that, apart from the average multiple moving up, over the past year, more Sensex companies have moved into the "expensive" zone.

While 21 of the 30 Sensex companies traded at a PE multiple of less than 20 times in June 2006, more than half the Sensex stocks are currently traded at a multiple of over 20 times their historical earnings.

Mid-cap stocks

Granted, the PE multiples for the bellwether indices have widened significantly over the past year. But would the stocks in the investment portfolios of individual investors have witnessed similar trends? Maybe not.

Individual investors, as well as mutual fund managers, tend to liberally pepper their portfolios with mid-cap stocks; but the PE multiples for the Sensex or the Nifty capture trends only for the highly visible frontline companies in India Inc.

But if you expected the PE multiple for the broader market to be much lower than that for the Sensex, you might be in for disappointment.

The PE computation for a broad market index, such as the BSE-500 (which captures a wide cross-section of mid-cap as well as large cap stocks), shows that the PE for this index is actually higher than that for the Sensex or the Nifty, at this juncture.

The weighted average PE for the BSE-500 is currently at a lofty 26 times trailing earnings, up from about 19 times a year ago.

If this is taken as a more accurate gauge of broad market valuations than the Sensex or Nifty, investors may have to tread cautiously indeed, as the earnings expectations factored into these multiples are quite high.

But when it comes to mid-cap companies, investors have greater leeway to reduce the overall risk to their portfolio through stock selection.

For one, unlike Sensex companies, earnings growth for the BSE-500 companies has largely outpaced stock price growth.

This suggests that the higher valuations of mid-cap stocks have been underpinned by better earnings growth.

Second, given the considerable divergence in earnings performance across companies, there continue to be opportunities for stock selection.

Companies such as Jagran Prakashan, UTV Software and Shree Cement have, for instance, witnessed a manifold expansion in earnings over the past year, reducing their historic price-earnings multiples. On the other hand, earnings growth for companies such as Apollo Hospitals or IndiaBulls Financial Services has significantly lagged the extent of stock price appreciation.

Third, mid-cap companies show greater divergence in valuations than frontline companies.

While the companies at the top end (Max India Financial Technologies, Reliance Natural Resources) enjoy three-digit PE multiples based on trailing earnings, the other end of the spectrum features companies such as Graphite India and Gujarat Gas, which trade at a multiple of less than 10.

Therefore, despite an average multiple of 26 times for the BSE-500 stocks, a good number of stocks in this basket continue to be available at a single-digit PE.

About 103 stocks, or roughly one in five in the BSE-500, are currently at PE multiples of less than 10 times their historic earnings.

This suggests that investors wary of current market valuations are more likely to locate winners while sifting through the mid-cap universe, rather than chasing frontline stocks.