Financial sector drags down Nifty's P/B value below historical average

Index trading at price-to-book ratio of 2.9x, compared to 20-year average of 3.5x

With the Nifty going past 10,000 points recently, the price-to-earnings (P/E) multiple has again become expensive. However, market players appear to be taking comfort in the fact that the price-to-book (P/B) value — another parameter to gauge market valuation — is at 2.9x, much lower than its 20-year average of 3.5x. This makes the broader market a value-buy at current levels, say experts. 

“The P/B value is a better valuation parameter during economic or financial distress that results in a sharp fall in earnings, followed by a quick rebound,” says Dhananjay Sinha, director (research), Systematix Institutional Equity.

The P/B ratio entered the value zone of 2.17x when the market fell sharply in March. The ratio had fallen to an 11-year low of 2.17x on March 23 when the index declined to a four-year low of 7,610. 

In comparison, the P/E ratio — based on the trailing 12-month (TTM) earnings per share (EPS) — hit 17.2x on March 12, its lowest since May 2014. Currently, it stands at 24.5x, nearly 20 per cent higher than its 20-year average earnings multiple of around 20x. “I expect the Nifty to reclaim its long-term average P/B of 3.5x over the next 12-18 months. This could translate into gains of 15-20 per cent from current levels,” says Sinha.

P/B ratio is calculated by dividing a company’s market capitalisation by its latest TTM net worth, which is also called its book value. It can also be calculated by dividing the share price by book value per share. For indices, the P/B ratio is calculated by dividing index value with its underlying book value per share. P/E, on the other hand, is calculated by dividing market capitalisation (or share price) by TTM net profit (or earnings per share).

 

 

P/B ratio is usually used to value asset-heavy sectors with volatile earnings, such as financial, metal, mining, and oil & gas, while P/E ratio is usually used to value asset-light businesses, such as technology, FMCG, and consumer goods manufacturing. 

The Nifty’s current book value is around Rs 3,513 per unit of the index, down 1.3 per cent from the recent high. The index's current EPS is around Rs 414, down 9 per cent from its recent high.

A prime factor that has dragged down the Nifty P/B value is the performance of banking and non-banking financial companies, constituting 40.6 per cent of the Nifty in December 2019. This was around 20 per cent in 2007. 

Over the last decade, there has been a steady rise in the weighting of asset-heavy players — bank & non-bank lenders such as HDFC, HDFC Bank, Kotak Mahindra Bank, ICICI Bank, and Bajaj Finance, besides Reliance Industries. Their gains came at the cost of companies in asset-light sectors. This resulted in a steady decline in the Nifty P/B ratio even though the index continued to rise.

At present, the NSE’s banking sector index — the Nifty Bank — is currently trading at 1.9x its underlying book value per share, a sharp decline from the sector's pre-crisis valuation of around 3.3–3.5x. Another factor favouring a value buy in banks is their relative underperformance to the broader market. That is, the Nifty Bank is up around 23 per cent from the lows of March 23, as against the nearly 33 per cent rise in the benchmark Nifty during the period. Historically, however, the Nifty Bank has always moved in tandem with the broader market or outperformed the benchmark index. Analysts are expecting a big re-rating opportunity in this segment.

However, some analysts argue a relatively-low P/B may not be the right parameter to look at because the book value across sectors will be adversely impacted during the pandemic. “The Covid-19 pandemic has drastically altered the earnings potential of corporate assets — or the book value — across sectors. For example, assets that airlines, hotels or retail company owns will yield much lower revenues and profits in the next three-four years due to social distancing norms,” says G Chokkalingam, founder & MD, Equinomics Research & Advisory Services, who considers the P/E ratio a reliable tool.

Before the Lehman crisis, the Nifty had peaked at a valuation of 6.6x its P/B and 28.3x P/E. In contrast, when the Nifty reached its lifetime high of 12,356 on January 16, 2020, the index was valued at 3.7x P/B and 28.6x P/E.