The Hindu Business Line : Market P/E: The real story

IF YOU think this article is about the true level of the prevailing price-to-earnings multiple for the market, you are wrong. There never can be one number that precisely tells you the state of the market.

The market P/E is an average. This average is distorted by extreme P/Es and also by how the P/E is calculated.

For instance, Max India's P/E, which is 342, will pull up the average, while Videocon International's P/E of 2.5 will drag it down. There can, thus, be no single number that accurately reflects the state of market valuation.

In particular, it may be appropriate to completely ignore the P/E statistics put out by the exchanges. They are based on aggregate profits and are not suitable for the Indian market.

Having said that, there is some value in computing these market averages to see how they have moved over time.

The numbers can give us a feel of the market sentiment and the prevailing bias in valuation. This bias can be compared to the growth outlook to discern if the bias is, indeed, justified.

Aggregate distortion: Statistics put out by the exchanges suggest that in the course of the rally during March 2003 and now, the P/E ratio has hardly moved.

The Nifty P/E at the end of March 2003 was 13.4. It is now 14.6. The P/E of the BSE-200, then 14.9, is 14.7 now.

Investors would be overjoyed at this. The statistics imply that earnings growth has more than kept pace with the growth in stock prices. The statistics, however, are misleading.

The P/E is low because it is calculated by dividing the aggregate market capitalisation by aggregate profits.

As petroleum sector companies with large profits are trading at significantly low P/Es, market P/E calculated on this basis tends to be lower.

As petroleum companies start totting up losses during FY06, the P/E would rise dramatically.

There is a rationale behind using aggregates. It is difficult to calculate P/Es for loss-making companies. However, as a few companies account for a substantial proportion of profits, this method may not be suitable for India now.

So, what is the P/E? It may be appropriate to compute an average of the P/Es of stocks, weighted by their market capitalisation. Based on such an average, the P/E for BSE-200 is now 21. The P/Es for Sensex and Nifty are closer to 20.

The P/E thus worked out, too, is affected by extremes, though weighting it by market cap reduces the effect of extremes.

So, what happens if we ignore the most richly valued stocks and most cheaply valued stocks in BSE-200 to eliminate extreme numbers? Then the P/E for the remaining 160 stocks works out to about 17.

What should be the P/E? `Is this P/E appropriate for the market?' is the next obvious question. For this, we have to turn to a stock valuation model. The inputs for the stock valuation model were:

Growth in earnings over the next five years would be equal to the average growth over the past three years.

For companies that reported de-growth, minimum growth of 13 per cent in earnings over the next five years was assumed.

Profits of public sector banks were assumed to grow at 10 per cent; those of private sector banks were assumed to grow at 15 per cent. Earnings growth for Bharti Tele-Ventures alone for the next five years was taken at 30 per cent.

Growth in earnings beyond the next five years was pegged at 9 per cent for all stocks.

A required return of 12.5 per cent was assumed for all stocks.

Proportion of profits paid out as dividends (dividend payout ratio) for the next five years was taken as equal to that for FY05 (average of about 25 per cent). Dividend payout ratio for subsequent periods was assumed at 50 per cent.

With these assumptions, the stock valuation model predicted that a P/E of 20.3 for BSE 200 would be appropriate.

The actual P/E of BSE 200 of 21 suggests that the prices of the top 200 stocks, mostly large-cap and mid-cap, have not strayed too far from their fair values.

Obvious caveats: That there are a number of caveats should be obvious. First, earnings need to grow by an average of 16 per cent over the next five years. If they do not, realised returns will be correspondingly lower.

Besides, even the achievement of 16 per cent growth in earnings will only result in returns of 12.5 per cent per annum.

Investment theory suggests that this is a fabulous rate of return. Many investors may, however, seek a higher rate of return.

But there are a few positives, too. We have assumed growth in earnings of 9 per cent beyond the next five years.

Corporate earnings could grow at a higher rate for a long time given the potential for the economy.

In addition, we have not considered the consolidated profits for stocks such as HDFC, Reliance, SBI, ICICI, GAIL, ONGC and Kotak Mahindra. That would lower the P/E even more. Importantly, the dividend discount model is often considered as a conservative tool for stock valuation.

When we count the pros and cons, what clearly stands out is that with a sufficiently long horizon, investments in large-cap and mid-caps look set to deliver attractive returns. A message that retail investors should not lose sight of.

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