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Suresh Krishnamurthy

The earnings growth factored into stock prices suggest that valuations have not scaled irrational heights. However, there could be a slight downside risk if economic growth does not materialise.

INTROSPECTION over the rise in stock prices in the last eight months is sure to throw up searching questions on the sustainability of valuations. But how far removed are the stock prices from their intrinsic values?

A definitive answer will be impossible, even for the savviest investor. However, if you consider the earnings growth required to sustain reasonable share price appreciation from present levels, the story is not that grim.

For half of the stocks in a universe of about 350 stocks, the earnings growth required over the next five years is about 15 per cent or lower. This suggests that stock prices are not far removed from their intrinsic values if it is assumed that economic growth will be higher over the next five years. Observers can at best accuse the stock market of optimism but not irrationality.

Caution necessary: Still, investors need to exercise caution for a number of reasons such as:

Earnings growth required for large-cap stocks is much higher compared to that of the broad market.

For the set of Nifty stocks, the required earnings growth over the next five years is about 25 per cent. This may be high for large mature businesses and the valuation of large-cap stocks already appears stretched.

Required growth in cash flows may be substantially higher than required earnings growth for companies whose cash flow per share is now substantially lower than earnings per share.

Cash flow per share is important because that is what drives stock prices over the longer term and not mere earnings growth.

So, low required earnings growth could be misleading for companies with inefficient working capital management or companies required to make large investments in fixed assets to meet this expected earnings growth.

This risk is higher in the case of smaller companies and companies whose earnings are cyclical. So, don't be fooled by the low single digit PE multiples in the case of companies with volatile earnings streams such as Metals or Banking or Oil company stocks.

The risk of a downturn in economic growth or the risk of economic growth not materialising is not factored into stock prices.

A required growth of a mere 15 per cent may be appealing. However, if growth rate does not pick up, even this low number may not be achievable and could lead to decline in stock prices.

These factors mean that a continuation of a broad-based rally in stock prices between December and February is an opportunity to exit from a number of stocks.

A starting point: Expected earnings growth built into stock prices is a good starting point to judge the potential of a stock to deliver returns.

A low required earnings growth does not per se make a stock attractive while high earnings growth will not make them unattractive from an investment perspective. For instance, the required earnings growth for Tata Motors is about 45 per cent. However, if the company's EPS were to grow at more than 100 per cent in the next couple of years, required earnings growth over the remaining years would decline significantly.

At the same time, only single-digit earnings growth may be built into stock prices of metal or banking or oil companies.

However, even that may be difficult to achieve since unfavourable movements in steel prices or interest rates or oil prices, as the case may be, can lead to a decline in earnings.

Having said this, large required earnings growth is definitely a red flag. Investors need to exercise caution in such stocks. Some stocks with large expected earnings growth rate include ITC Hotels and Gillette India.

Earnings of these stocks need to grow at above 100 per cent annually over the next five years. Some stocks such as NIIT, EIH, Titan Industries and Zee Telefilms require earnings growth of more than 50 per cent annually over the next five years.

Stocks that require low single-digit growth rate include that of Container Corporation, Indian Rayon, Raymond, GE Shipping, Moser Baer, Tata Power, Fag Bearings, BPCL, Neyveli Lignite and Apollo Tyres. Investigation into such stocks may unearth worthy investment candidates.

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