Are India's stock markets overvalued?

DEBATE

The economy's strong and India Inc continues to do well, but the question is whether the risks have been factored in as well.

Deven Choksey,
MD,
K R Choksey Securities

We're trading at less than 18 times the projected earnings for FY08 "" at a P/E of 20, our analysis projects a year-end sensex of 16800

While short-term valuations have a tendency to correct for consolidation, we are bullish and believe India's valuations are here to stay over a longer period. There are several reasons for this. The US Fed has kept the benchmark interest rate unchanged at 5.25 per cent and overall nervousness is abating.

Though some negative triggers relating to US/global weakness still exist, the overall markets seem to be in a consolidation phase. The macro-indicators are all positive "" IIP is growing at 13.6 per cent, we had a surplus current account in the March quarter, and WPI inflation has come under control at 4.03 per cent. Liquidity is at its best and two mega issues, ICICI and DLF, have sailed through smoothly.

The growth in the market cap of Sensex firms is well ahead of their profit growth and we are already experiencing P/E expansions. The market and its indices are slaves to the earnings "" as long as there is growth in the earnings of front-liners, we will have a rising market curve.

Another factor worth keeping in mind is India's relative performance vis-à-vis other BRIC competitors. At 5.5 per cent returns (for January to May) in local currency terms, India's returns are lower than China's 53.6 per cent, Brazil's 17.5 but higher than Russia's where earnings declined by nearly 9 per cent. In dollar terms, thanks to the sharp appreciation of the rupee, India returns rose to 15.1 per cent "" China was 56.7 per cent and Brazil 30.5 per cent.

At 14000+ levels, the Sensex is nearly 20 times one-year (FY2007) trailing earnings. This looks expensive compared to other emerging markets on an absolute basis, but Indian companies are growing at 25-30 per cent and that calls for re-rating. Even during the worst of the post-1970 recession in the US, its market cap was around 158 per cent of its GDP, while that of Japan was over 130 per cent of its GDP. In India, we are just over 100 per cent. Summing up, we feel the markets will see new highs once Q1FY08 results start pouring in. In 2007-08, Sensex earnings are expected to be in the region of 820-860, the average estimate being 840. Taking that as the base case, we are at less than 18 times FY08 earnings. At a P/E of 22, our sensitivity analysis suggests a year-end Sensex target of 18480; at 20, it'd be 16800 and at 18, 15120.

Some factors that could upset things are the threat of high interest rates on rate-sensitive sectors like auto and real estate and that of appreciating rupee on export dependent sectors like IT and textiles. The RBI's long-term target for inflation is closer to 3 per cent and medium-term target is at 4-4.5 per cent. This is a matter of concern as it could suggest monetary tightening. The dollar and the Fed's actions need to be watched as well. Looking broadly at the economy, we can see a few waves developing:

Consumption Wave: Favorable demographics and higher disposable incomes leading to higher aspirations and conspicuous consumption in FMCG, textiles, aviation/travel/tourism, organised retail and realty/property sectors.

Infrastructure Wave: India is trying to achieve in the next five years what it did not do in the last 55. Huge investments are required and planned for in power, ports, airports, railways and SEZs, leading to unprecedented opportunity for construction and contracting companies.

Outsourcing and Globalisation Wave: World-class Indian companies in IT/ITES, pharma, auto and ancillaries, garments setting their sights high and proclaiming, "the world is not enough".

Consolidation Wave: Companies trying to achieve world-class scale in commodities (metals, cement) and BFSI sectors through mergers, demergers and acquisitions.

We believe that these four waves are huge tidal waves and may last for the next three-five years or even more. Investments in carefully selected scrips in these sectors may lead to winning investment returns. Finally, it is important that even the best stock in the world has to be priced close to its earning potential, meaning that, we must remember to pay justifiable multiples (P/Es).

Vibhav Kapoor,
Group Chief Investment Officer, IL&FS

Given FY08 projected earnings, a fair P/E would be in the region of 16-16.5, while we are trading at 17.5-18 the FY08 projections

The Sensex having gone up from a low of 3000 in 2003 to close to 15000 now does make it look as if the markets are over-valued, but this sharp upswing has been accompanied by an equally sharp rise in the earnings of the Indian corporate sector. Earnings growth for the top 500 companies has been exceeding 30 per cent per year over the past three-four years.

Thus the rise in the markets has been accompanied by an equally strong upswing in the fundamentals arising largely from a major boom in both investment and consumption in the Indian economy.

However, there is also no doubt that expansion in global liquidity as well as in India has led to a huge amount of funds flowing into equity markets the world over. This has been accentuated in the case of emerging markets led by the BRIC economies.

This has also impacted the Indian markets where judged by almost all parameters, valuations have expanded over the past few years to levels where doubts are beginning to emerge in respect of their valuations. Going by the simplest of these parameters, that is, P/E ratios, the valuations of the markets have increased from a low of 10 times earnings to a high of 18 times FY2008 earnings at present.

The market cap of the Indian equity markets has recently exceeded the $1 trillion mark. This places India among the top 10 countries of the world by market capitalisation. One of the important parameters used by global analysts is the market cap-to-GDP ratio. At present, this ratio has expanded to 1 for India as compared to 0.3 to 0.4 three years ago.

Most of the developed markets have a market cap-to-GDP ratio in the region of 1-1.2 and therefore, the Indian markets, despite their volatile nature and higher interest rates, are now very much valued within this range.

A third valuation parameter which is widely used relates to the risk-free interest rate and the equity premium thereon depending upon the volatility of the markets. In India, the risk free rate (10-year government bonds) is at present around 8-8.25 per cent. Assuming a risk premium of 7 per cent for volatile markets such as India, investors would logically expect a 15 per cent earnings growth to justify a P/E ratio of 12.5 times future earnings (inverse of 10-year risk-free rate of 8 per cent).

Since the expected earnings growth for the next two-three years is in the range of 18-20 per cent, the fair P/E of the Index should be about 1.2-1.3 times the inverse risk-free rate of return. This gives us a fair P/E of 16-16.5 times. Considering that the markets are now trading at multiples of 17.5-18 times FY2008 earnings, they appear to be just entering the overvalued zone.

However, it may be too simplistic to value the markets on a market-wide P/E ratio when different sectors should trade at different valuations depending on their perspective growth rates. In this sense, the Indian markets have been fairly rational "" while some of the sectors such as capital goods and infrastructure-related industries are trading at high multiples of 30-40 times their earnings, others such as commodities, FMCG and interest rate sensitives like automobiles, and more recently, Information Technology have been given a thumbs down by the markets for various reasons.

While the markets have still not reached the euphoria stage, they are definitely tending towards an over-valued range and a further 5-7 per cent increase in the markets over a short period of time could make them expensive in relation to growth prospects.

As it is, the markets seem to be now discounting the FY2008 earnings "" at least nine months ahead of the close of the financial year. Any further increase in interest rates and/or lower than expected earnings would definitely be a cause of concern in terms of the further upside valuations.