Is The Current Valuation Justified?

Valuation as measured by PE ratio is a strong indicator of how cheap or expensive a stock is as compared to its peers or as compared to its historical multiples. When companies trade at a high PE ratio, it is essentially an indicator of PE expansion due to high expectation of growth. If the growth in earnings does not materialize, the price of stock will correct in future. The objective of this article is to understand whether the top companies in the Indian stock market are fairly valued.

In this study, we have selected 500 companies and sorted them based on their market capitalisation as on November 1, 2018. On this set of companies, second filter applied is based on the PE ratio from 2003 to 2018, and the set is divided into 10 deciles based on the PE bands. We obtain the number of companies in each decile and calculate the percentage of companies in each of the decile. The companies that have reported numbers for that year were included in the study.



In table -1, refer to the year 2003, in the PE band of 5.1 to 10 there are 27% companies, which is the highest number in that year. There are large number of companies having PE lower than 25. This indicates that a large number of companies were in low PE bands and in the highest PE band of 45 and above there were only 4% companies.

Now let’s analyze the trend, from 2003 to 2014 as indicated in Table-1, large number of companies are in low PE bands. We see a shift in companies from low PE band to highest PE band between the years 2015 to 2017, in these three year periods of PE expansion; investors were either hopeful of high growth rate in earnings or the excess liquidity may have led to increase in share prices. Now, as we look at 2018,we can see that 19% of companies are in PE band of 15.1 to 20 and the distribution of shares between all PE bands is fairly balanced.

Remembering some of the famous lines by veteran investors like Warren Buffet and Peter Lynch which gives us a perspective towards the price of the stock:



"Price is what you pay and value is what you get"




"If you can follow only one bit of data, follow the earnings -assuming the company in question has earnings. I subscribe to the crusty notion that, sooner or later, earnings make or break an investment in equities. What the stock price does today, tomorrow, or next week is only a distraction. We need to analyze the price in context with earnings growth."

Earnings growth is a strong indicator followed by many investors and analysts. We analyze the growth rate in earnings for the same set of companies. Refer to the calculation in Table-2, here we have calculated the growth in reported earnings and classified the companies in one of the decile based on the growth in earnings and then calculated percentage of companies in each decile.



Table -2 is showing very unique information across all the years from 2003 to 2018. Here, maximum numbers of companies are either having earning growth less than 5% or earnings growth is more than 45%. In the years between 2015 to 2017, when the PE ratio of most of the stocks increased and there were very few stocks with PE ratio lower than 10 (refer to table 1), the data on earnings growth suggest a contrary view. We can see that for 46% companies in 2015,the growth in earnings is lower than 5%. Even from 2016 to 2018, a large number of companies are having earnings growth lower than 5%.

In 2018, we can see that 43% companies have earnings growth lower than 5%. Although we have seen that the valuations are correcting and around 19% companies have PE multiples in the range of 15.1 to 20 (refer to table 1), the question is whether the market now can be said to be fairly priced?

When the stock market rally is supported by fundamentals, we can be assured that these valuations are sustainable, but if the rally is liquidity driven there can be issues when liquidity dries down. Similarly, if shares are trading at a very high PE ratio and the earnings growth does not follow suit, those stocks will surely correct. We expect that there will be some more correction in the PE multiples if earnings growth do not keep pace in the near future. Retail Investors should not hurry to make investment decisions seeing the market corrections in the month of October and November 2018. A careful fundamental analysis of the high growth stories need to be made before making an investment call.

Dr. Ruzbeh J. Bodhanwala and Dr. ShernazBodhanwala, are Faculty with Business School at FLAME University