Bulls make a case for book value

While price-earnings multiple is near all-time high, price-to-book value ratio is 45% lower than its peak

The bulls have now turned their attention away from corporate earnings and its derivative, the price-earnings (P/E) multiple, to valuations based on book value or net worth per share. While the P/E multiple of the market is near an all-time high, valuations still look reasonable on a price-to-book (P/B) value basis, say experts. 

The benchmark NSE Nifty50 Index is currently trading at 3.5 times, or 3.5x, its underlying book value (or net worth per share) of Rs 2,926. This compares favourably with the historical average P/B valuations of 3.5x. In the previous bull run, the index had peaked at around 6.6x its book value in the first week of January 2008. 

During the dotcom boom, the index had peaked at 5.1x its underlying trailing book value.

In contrast, the P/E multiple (on trailing basis) has now almost touched the previous highs. At Friday’s closing price, the Nifty was trading at 26.4x its underlying trailing 12 months’ earnings per share of Rs 385. The index peaked at a P/E multiple of 28x, both during 2008 and at the peak of the dotcom boom in 2000. 

This now leaves little room for a further expansion in the earnings multiple of the broader market, though the P/B value can still expand without triggering the alarm bells (See chart).

At a recent conference, Morgan Stanley’s Ridham Desai justified that the markets were not overvalued based on the P/B multiple, while the P/E multiple was a bad metric to judge valuation. “The P/E multiple is a not a good metric to judge the markets in the current circumstances. The P/B value is a good method to find value. On this scale, valuations are currently at the mid-point of India’s historical range of 2-5x,” said Desai.

Others analysts, however, say it is a bull market explanation to justify the current valuations despite a poor earnings growth. “The book value represents a company’s past, while equity investors buy a company’s future. A company’s book value may be high even if it is doing badly, but has large accumulated earnings. In the current circumstances of economic and corporate slowdown, the earnings become even more important as it gives confidence to investors to stay put,” said G Chokkalingam, managing director, Equinomics Research & Advisory.

Nifty companies’ earnings have been stagnant in the last three-and-a-half years at around Rs 390 per share and down nearly 10 per cent from the all-time high reached in the last quarter of 2014.

Also, if investors do look at book value then they should also consider what they earn on it, which is what return on equity (RoE) is. “Book value or net worth is as good as the returns it generates for investors. But the recent decline in the index P/B value has coincided with steady erosion in index companies’ RoE, which has nearly halved from its peak in late 2007,” said Dhananjay Sinha, head of research, Emkay Global Financial Services.

Index companies’ RoE is now down to 13.1 per cent, from record high of 28 per cent in May 2007. It was 18 per cent at the height of the 2000 boom. 

A recent study by Emkay Global suggests that Indian corporates’ RoE and return on assets are now at the lowest levels since 1991. “This demands a lower P/B value for listed stocks and not higher as bulls are pushing for,” adds Sinha.

Also, a large part of the increase in the underlying book value of the index has been due to changes in index composition rather than organic growth in the book value of index companies. From 2007 to now, the weight of net-worth heavy companies from the financial sector has doubled in the index, largely at the expense of capital-light manufacturing companies. Banks and financials now account for nearly 32 per cent of the Nifty, up from 17.3 per cent at the end of 2007. This has pushed up the index book value without giving a matching bump up in its earnings. 

For example, State Bank of India’s net profit is half that of Tata Consultancy Services (TCS) despite double the net worth of the latter. While the net worth of HDFC Bank, the most profitable bank, was higher than TCS last fiscal year (FY17) with 60 per cent of its profits.