Index PE @ 28 BUY Or SELL

Often, in high growth markets like India (emerging markets), the PE (price-to-earnings ratio) is high as investors are willing to pay that much more for the estimated growth. The most important aspect in a growth environment is how much should one pay for the estimated growth. Is there any additional risk of investing in high growth environment? What are the risks of investing in equity when in general the PE ratio is high for majority of the stocks, including the index? The risk of investing in high growth environment is that there is always a possibility that the estimated growth may never materialise and the investors may find themselves trapped in stocks or indices at higher prices.

It is very important while investing in growth stocks that one should realistically estimate the growth rate. Most investors get punished for overestimating the growth rate while opting to invest in growth stocks in growth environment. While the risks for investing in high PE stocks is known, majority of the investors carry a perception that investing in low PE stocks is less risky and that excess returns are possible only by investing in low PE stocks. Let us understand what is PE multiple actually and what factors determine a PE. PE multiple demystified :- PE ratio, also known as the price multiple or earnings multiple, is often used by investors and analysts alike to compare valuations of stocks. PE ratio tells us how much is the market willing to pay for a single share for every rupee it earns as profit. If PE ratio is 20 for a listed stock, it simply means that market is willing to pay Rs 20 per share for that stock for each rupee of profit it makes. It is important to understand that loss-making companies will not have a PE ratio.

Same logic applies for the index PE ratio.

"As PE ratios change over time, the criteria for what constitutes a low or a high PE will also change."

While there is no doubt about the popularity of PE ratio and its usefulness, there is considerable amount of confusion on its interpretation. There is common perception amongst the market participants that low PE is cheap and that investing in low PE stocks can be more profitable. Few analysts suggest that a stock trading at less than 8 times its earnings is considered cheap. Many market observers use PE as a relative measure. For example, if a stock trades at less than half of the price-earnings ratio of the market, it must be a cheap stock to buy. Few investors compare the PE of the stocks to its historical average and few others compare it with the other stocks in the same sector. For example, a technology stock such as HCL Technologies that trades at 15 times earnings may be considered cheap because the average PE ratio for technology stocks is 20, whereas an electric utility company such as NTPC that trades at 13 times earnings can be viewed as expensive, because the average PE ratio for utilities is only 10. Most investors think investing in stocks or index at high PE ratio is risky. Says Amit Pokharna who is a Chartered Accountant and a growth stock investor, "Investors ought to understand one thing about the price-earnings ratio, namely, the ratio will increase as the expected growth rate increases. So do not worry. You may see higher PE ratio for key benchmark indices or even for your favourite growth stocks. The companies that are more efficient and predictable about generating growth will reflect higher return on equity and these companies a stock trading at less than 8 times its earnings is considered cheap. Many market observers use PE as a relative measure. For example, if a stock trades at less than half of the price-earnings ratio of the market, it must be a cheap stock to buy. Few investors compare the PE of the stocks to its historical average and few others compare it with the other stocks in the same sector. For example, a technology stock such as HCL Technologies that trades at 15 times earnings may be considered cheap because the average PE ratio for technology stocks is 20, whereas an electric utility company such as NTPC that trades at 13 times earnings can be viewed as expensive, because the average PE ratio for utilities is only 10.

Most investors think investing in stocks or index at high PE ratio is risky. Says Amit Pokharna who is a Chartered Accountant and a growth stock investor, "Investors ought to understand one thing about the price-earnings ratio, namely, the ratio will increase as the expected growth rate increases. So do not worry. You may see higher PE ratio for key benchmark indices or even for your favourite growth stocks. The companies that are more efficient and predictable about generating growth will reflect higher return on equity and these companies will always trade at higher multiple of earnings. The PE ratio will intuitively lower for high-risk firms with higher cost of equity."

Low PE investing Story
Akash is a value investor and does not understand why investors chase growth and pay exorbitant prices for growth stocks. One day he was excited to read in a leading financial daily in India that an academic study showed that one could beat Sensex returns by buying low PE stocks. Inspired by the academic research findings, Akash started hunting aggressively for all those stocks that are trading at a PE lower than 8. He was happy to find a list of good 50 to 60 stocks that were trading at a PE lower than 8. He then decided to invest in 10 stocks from the list of 60 stocks with PE less than 8. After one year, while the Sensex climbed up by more than 20 per cent, Akash was surprised that his portfolio was not even generating positive returns. His portfolio returns were nowhere near the returns promised by the academic study that he read in the financial daily. His friends, who adopted a different strategy and invested in higher PE stocks, were performing in line with the markets, if not beating them. Akash got frustrated and decided to research deeper into his holdings. To his own surprise, he found that the low PE stocks that he was holding were actually highly risky stocks with huge variation in earnings. He also found that most of the stocks did not have a good management track record.

"If our estimates are met, Nifty EPS for FY19 will be Rs 491 and the Nifty EPS for FY20 will be Rs 617, which translates into 25.6 per cent EPS growth. Elara Capital"

Finally, after spending a couple of months more holding on to his underperforming portfolio of low PE stocks, Akash decided to put all his money into high growth stocks and mutual funds that invest in high growth stocks. Moral :- Not all stocks that trade at low PEs are cheap and there is no evidence that buying low PE stocks is tantamount to value buying.Higher price-earnings ratio – a trend! PE ratio depends on expected growth, risk and cost of equity. What we are seeing is a general shift in PE ratios (upwards). For example, the average PE ratio for the last 10 years for Nifty is 21. However, if we consider the average Nifty PE ratio in the last five years (2014-2018) alone, we find that the average PE ratio for Nifty has shifted northwards at around 23. The average Nifty PE ratio for the period 2008 to 2013 was 19.6. 

This may well be a global trend with the average PE being higher in recent times when compared to the average PE of previous 10 or 15 years. Investors will have to get used to market environment where in general the PE ratio will be higher than the levels we are used to. The higher PE could be a result of higher profitability, lower interest rates and or lower cost of equity.

The graph above helps deduce where Nifty will be in one year's time depending on the price-earnings multiple and the EPS growth delivered by the benchmark index. For FY20, the markets are expected to trade with 23 PE and EPS growth at 20.4 per cent. In these conditions, we can safely say that Nifty should most likely reach 14,000 i.e. about 20 per cent rise from current levels. Even if the growth rate falters we can conservatively assume a Nifty EPS growth at 15 per cent and a Nifty PE of 21 for the next year, then we are still looking at a level of 12,219 i.e. about 6 per cent from the current Nifty levels of 11,500.

I N T E R V I E W

Vineeta Sharma
Head of Research, Narnolia Financial Advisors Limited

What is your EPS estimate for FY20 for Nifty 50?

Nifty EPS is expected to grow by 10.4% for FY19. We expect growth of 20% over FY19, making Nifty EPS of Rs 606 for FY20

Is the NIFTY PE @ 28 justifiable?

Nifty index is a product of Nifty EPS and valuation multiple, PE. In the past, Nifty EPS has been impacted by several cyclical and one-offs, like Tata Motors' provisioning for impairment, inventory losses in OMCs, etc. In this sense, historical PE does not give a very clear indication of the market. On a forward basis, Nifty is trading at 19.3 times FY20E EPS, which is almost the middle of 17-21 times historical range of forward PE.

Which sectors in your view will lead in terms of earnings in FY20 and which sectors may drag in terms of earnings growth if we consider the Nifty 50 basket?

In terms of sectoral performance, we expect banks, especially the corporate lenders, should outperform in terms of earnings growth, driven by revival in the NPA cycle and and lesser incremental stressed assets. While banks contributed only 2.5 per cent to the aggregate net profits of our 165 coverage companies in Q4FY18, they will now contribute 20 per cent to the total profits. We also expect cement, defence and capital goods sector to do well as infra spending should be the focus area of the new government

"Any company that trades at a low priceearnings ratio because it has little or no prospects for growth in the future is a far riskier company for investment than a company trading at higher price-earnings ratio but promising visible growth."

Dinesh Thakkar
CMD , Tradebullls Securities

What is your EPS estimate for Nifty 50 for FY20?

Currently, EPS for Nifty 50 stands around Rs 438. Even though Q3 results were more or less in line with expectation, earnings estimate have been cut by around 11 per cent for FY20. We estimate EPS for Nifty 50 to be around Rs 552 for FY20

Which sectors will contribute the most to the Nifty earnings in your view and which ones will underperform?

For FY20, the sectors that are expected to dominate are financial services, including banks, auto, capital goods, consumer discretionary and IT. Sectors which are expected to underperform would be realty, telecom and energy. We are neutral on sectors like FMCG, metal and pharma.

The NIFTY PE is at 28. What are you advising your clients?

Going forward, we may see a lot of stock-specific actions. Long term investors can ride the momentum with stocks, but for the short term investors, we would advice to book partial profits. Traders who are looking for initiating fresh buy positions should wait for correction, instead of buying at lifetime highs. Market continues to remain in an uptrend in the medium-term, so buying on dips continues to be our preferred strategy.

"Forward PE is the current share price divided by the expected earnings per share in the next fiscal. A forward PE ratio being less than the current PE indicates expected increase in earnings, assuming accurate analyst predictions. If the forward PE ratio is higher than the current PE ratio, it indicates decreased expected earnings."

Conclusion

 The PE ratio is the most widely used ratio by market participants as it is easy to calculate and readily available. PE ratio is related to a firm’s fundamentals, and as the fundamentals improve, it is but natural for the PE ratio to expand. Investors, instead of looking at the historical average of long period, should pay more weightage to the average of recent three to five years as it is seen that different periods reflect different multiples. Investing in high PE environment can be risky only if the estimated growth is not delivered, but there is always a chance that the actual growth delivered is better than the estimated growth and, in such a scenario, the market can beat investors expectations.

While the market is estimating a growth in earning in the range of 20 to 25 per cent for Nifty 50. It is possible that due to the contribution from financials and other growing sectors, the actual growth may turn out to be 30 per cent in the Nifty 50 basket.

It will be erroneous to look at PE levels of indices and stocks and compare it with the historical averages and decide not to invest. It is a stock pickers' market and one should not simply look at indices valuation and make investment decision. Investors have to identify those stocks that are trading at relatively lower P/Es and the growth is intact in such stocks.

Ideally, investors should be spending time in finding out companies that are growing at a decent pace with sustained profitability. Also, these companies should be conservatively financed and should not have been yet recognised by the markets.

Owing to the increased liquidity (FIIs+DIIs), higher earnings growth due to low base effect, slowing global economy making India look attractive, we have a situation of more money chasing few quality stocks. In such a scenario, we can expect the PE multiple to remain inflated.

Looking at various factors discussed in the cover story, we believe investors can still buy Nifty at the current levels and look at Nifty touching 14,000 levels one year down the line. This translates to a decent 20 per cent upside in the key benchmark index. It is a clarion 'Buy' from our side as we believe that the growth will be delivered.