We take a look at equity valuations for the Nifty 50 in August 2016 and find that markets are a little expensive from an earnings point of view.
We use data from the NSE website starting from when it is available in January 1999 to look at the P/E Ratio, P/B ratio and the dividend yield of the index and compare it to past history.
In the chart above, the red areas highlight when the PE ratio is significantly higher than normal implying that markets are expensive and future returns are likely to be lower than in the past. On the other hand, green areas show when the PE ratio is significantly lower than normal implying that markets are cheap and returns from equities should be higher than average.
As on 18th August, the price to earnings ratio of the Nifty was at 23.7 which is higher that its long term average of 18.7 and is also greater than one standard deviation away from this average. What this means is that we are now in expensive territory from an earnings point of view. Markets have run up in the last few months and, if we use history as a guide, we may not see these returns continue in the short to medium term.
Similar to the PE chart above, red areas in the PB chart denote times when markets are expensive whereas green areas show when markets are cheap relative to history. The price to book ratio of the Nifty was at 3.4 which is close to its long term average of 3.5. On the basis of book value, markets are trading in the normal range.
The dividend yield chart denotes value in a manner that is opposite to the PE and PB charts above. When the dividend yield is higher than normal, it means that markets are cheap. Similarly when the dividend yield is lower than normal, it is a sign that markets are expensive. In August, the dividend yield of the Nifty was roughly 1.2, which is below the long term average of 1.5, but still within one standard deviation of the mean. This means that on the basis of dividend yield, markets are trading in the normal range.
Even though the PE numbers are showing that markets are expensive, the PB and dividend yield indicate that it is in the normal range. This discrepancy can be explained by the fall in commodity prices over the last few years and also by low capacity utilisation in the economy. Indian firms have good assets, but may not be utilising them fully leading to low profitability. Any pickup in demand for affected industries will lead to higher utilisation levels and a non-linear jump in profits. This in turn would cause a spike in earnings and bring the P/E ratio lower.
Alternatively, firms may have older assets on the book at higher prices which may not have been revalued after the fall in commodity prices. The classic case in point in is the steel and the mining sector. Any revaluation of these assets could bring the book value down, causing a spike in the P/B ratio.
In the last few years there has been a tendency for analysts to be very optimistic about a turnaround in the Indian economy. We have seen forecasts of high double digit earnings growth only for them to be downgraded to single digits as the actual numbers come through. Markets have rallied recently on the prospects of a good monsoon and progress in the reforms process. The government has passed major legislation like the Goods and Service Tax through parliament and has been very active in building public infrastructure. The high PE ratio reflects optimism from the market that earnings of companies will follow and grow faster looking forward. These changes in our economy will undoubtedly have beneficial effects in the medium to long term, but how long it takes to reflect in company numbers remains to be seen. Keeping this in mind, the long term equity outlook is positive, but it would be prudent to temper our expectations of high returns in the short to medium term.
Rishad is the founder of Kairos Capital. He started his career with Standard Chartered Wealth Management and has extensive experience in markets, particularly in terms of mutual funds and stocks.