Valuations frothy? Profit and market cap moved in sync in 5 years

Analysts: upside in the markets from here will be driven by earnings growth

As benchmark indices continue to reach new highs almost every other day, a heated debate rages on: Have stocks outpaced their fundamentals, and can earnings keep up with these valuations?

Only time will tell if the earnings growth potential justifies the Nifty 50’s current valuation, which hovers at nearly 25 times its FY24 earnings. In the past five years, however, the rise in profit and stock price growth for India Inc have moved in tandem, lending credence to the notion that the markets are slaves to earnings growth.

Consider this: Earnings for Nifty 50 companies increased at a compound annual growth rate (CAGR) of 18 per cent between FY19 and FY24, almost mirroring the growth in market capitalisation during this period.

“This shows that the market is trading at a fair valuation,” says Gautam Duggad, head of research of institutional equities at Motilal Oswal Financial Services. “The 10-year average price-to-earnings (P/E) multiple is about 20.2x on a one-year forward basis, similar to current valuations.” He expects Nifty 50 earnings growth to compound at a 15 per cent CAGR over FY25 and FY26.

In FY24, the Nifty logged earnings per share of Rs 989. If earnings compound at 15 per cent and valuations remain at current levels, the index could trade at 26,000 by March 2025. However, projections for earnings growth and valuations vary among analysts. Some are comfortable with near-term valuations of the markets or a stock overshooting long-term averages if the potential for earnings growth is robust.

“On the aggregate market level, the India story is still priced in about halfway through this earnings cycle,” says Ridham Desai, chief equity strategist-India, Morgan Stanley, in a recent interview with Business Standard. “Earnings could continue to compound at a rate of 20 per cent over the next four-five years. Some stocks may be a bit ahead of their earnings outlook, but others are lagging.”

Deepak Jasani, head of retail research at HDFC Securities, notes that both profits and earnings don’t grow linearly. “Nifty profits grew well in FY23 and FY24, but in earlier years, profit growth was not very sharp. Similarly, there is no linearity in the growth of market cap. India’s (real) GDP would grow at 6.5-7 per cent, nominal GDP at 10-11 per cent, and corporate profitability could grow at 13-16 per cent. An overall CAGR of 13-14 per cent in market cap over the next three to four years is possible. If GDP growth remains steady, there won’t be much to worry about regarding corporate profitability growth,” he explains.

At a more granular level, some sectors have lagged in their earnings growth, while others, particularly financials, have seen earnings growth far outpace their market cap growth over the past five years. Kotak Institutional Equities (KIE) recently noted that tracking index-level valuations can be misleading. “A superficial view of the Indian market is typically based on the valuations of the Nifty 50 index. The index may be reasonably valued in the context of historical valuations and bond yields, but most other parts of the market are trading at full-to-frothy valuations after a massive rerating in their multiples in the past 2-3 years,” the report states.

KIE, in the report, highlights that the 50 companies comprising the Nifty 50 have diverse valuations ranging from 7x to 100x. Stocks currently trading below 20x valuation have accounted for 67 per cent of the incremental profit growth over the past five financial years.