The bull and bear case for equity valuations

The Nifty-50, last week, scaled yet another peak of 25,000 in its relentless momentum over the last four years. While the primary driver — earnings growth — has been dissected in several ways, there are other drivers of valuations that largely go unnoticed.

Rule number one in fundamental investing is that equity valuations are driven by earnings potential. The higher the growth outlook a security promises, the higher would be its valuation. This holds true for the daily grind of stock investing and analysing.

But then there are other glacial factors that gather under the surface, impacting valuations. These are not as tangible as earnings announcements. But either through quantitative application or  speculation, these factors do impact valuations. The valuation gap left unanswered by earnings growth is partially filled by these factors and investors should be aware of the changes.

For instance, the earnings growth of Nifty-50  in the last two decades is arguably similar: 11 per cent CAGR from 2004 to 2014 and 10 per cent CAGR from 2014 to 2024. But in the same period, Nifty-50 one-year forward PE has moved from 11.8 times in 2004 to 14.7 in 2014 to 20 times now. Despite similar earnings growth, the constant expansion of Nifty-50 PE over the years can be linked to lower risk, higher duration of growth and better investing environment.

We analyse the possible drivers and comment on the sustainability of PE expansion basis these.

The base case

A stock (or any security) whose earnings grow at 11 per cent per year (equal to Nifty-50 growth) till terminal stage (post which 2 per cent secular growth is generally assumed) can be bought today at 18.3 times its one-year forward earnings, assuming the total cost of capital is around 10.5 per cent. This also assumes that the earnings turn into free cash flow at 90 per cent, ie FCF/earnings is 90 per cent; the cash is then discounted at the rate tied to financing plus a risk-premium. Assuming this is split equally between debt (8 per cent cost of funds) and equity (13 per cent), it works out to a total cost of capital at 10.5 per cent, also referred to as WACC.

This leads to the base case PE of 18.3 times compared to Nifty-50 trading at a peak of 20 times for the last one year. This implies a  gap that requires a justification. What can these be?

Lower risk assumption

A lower risk assumption can increase the multiple. With lower risk associated with the investment, the bids can sufficiently increase, pushing valuations. Quantitatively, the discount rate or WACC can be viewed as the hurdle rate beyond which any surplus can be claimed by the equity holder. The lower the hurdle rate, the higher the claim of the equity holder.

If a project is fully financed by debt, which has an 8 per cent cost, then funds left after paying debt accrue to the shareholder. Similarly, equity capital, which is the other capital, should consider risk free rate, risk premium and company beta. Flowing from larger macroeconomic factors of a country, these metrics are nearly passive with one or two shifts per decade.

To an extent, the current premium in valuations can be partially explained by lower risk perception in investments. The risk-free rate is drawn from 10-year GoI bond yield, which is currently at 7 per cent. In January 2014, this rate was 8.8 per cent which, when plugged into the base case, yields an acceptable PE of 16.4 times. As can be seen in the table, PE ratios have marched upwards, egged on by lower bond yields in the last two decades.

A similar extrapolation of yield decline by 100 bps expected in the next two years can provide a case for expansion in the PE multiple to 19.6 times in the base case. For a speculator, this would not be a wild trade. India’s inflation, even if hovering above average, is faring well compared to worldwide inflation. This provides elbow room for monetary action to induce growth by lowering rates. In the developed economies, the question of when and not if rate cuts are announced has evidently watered down with persistent inflation. But once the cycle starts, the domestic rates will be quick to adapt after two full years of high policy rates.

 On the other hand, conservatism should discourage such extrapolation as one would be betting against the central bank and even ahead of it. Also, the current yield of 7 per cent holds most of the rate cut speculation. Even assuming lower yields, the second order effect may prevent the full flow through to lowering the discounting rate. Currency, RM costs, credit growth and health, demand outlook, price competition and other business/economic variables and their impact on risk perception are unknown and far too complex to assume. In other words, what if yields decline, but earnings growth, which is taken for granted, does not materialise as expected?

Further, the rate cut cycle may not even be as sharp as seen in earlier periods, with global rates acting as a floor. Internationally, the last two decades witnessed highly accommodating monetary policy with easy money supplies. It has to be seen what stance developed central banks take in the current iteration when their rate cut cycle starts.

It is important to note that fundamental risk metrics such as WACC are not to be assumed based on forward expectations but are to be inferred from current market conditions.

Earnings growth expectations

In the base case we assumed a 10-year period of high growth — 11 per cent earnings CAGR for 10 years —  before stable stage rate (2 per cent per year to eternity). In cases where there is a strong visibility of growth for a longer duration, one more stage of growth is added. For instance, in the base case, adding one more stage of growth for five more years at 7 per cent earnings CAGR can push the forward PE multiple from 18.3 to 19.9 times. In simple terms, we are front-loading the growth assumption to push valuations.

This is primarily practised in valuing high-growth companies, such as e-commerce, internet-based, or new-age companies, which can take a long time to mature and have no earnings to speak of in the current term. However, this is also reflected in mature companies with a track record of growth, which is then extrapolated into the future, basis the track record.

Of the Nifty-500, there are only 17 companies with no earnings decline in the past 10 years. Of the lot, mature large-cap companies HUL, Asian Paints, HDFC Bank, Kotak Mahindra Bank, Abbott India are notable. These companies have traded at a premium to the index and this premium has been on the rise as well. Clearly, a longer track record of growth (despite being nominal), has been rewarded with an above-average and increased valuation multiple. Investors bid on the company’s ‘habit’ of growth, which translates into higher valuations.

However, at some point, this can face a stiff challenge as well. As can be seen in the table, the rising premium of Asian Paints has stalled, coinciding with the company reporting a profit decline in the last two quarters. For HDFC Bank and Kotak Mahindra, despite stellar record of growth, the premium is on the decline. But FMCG leader Unilever has reported a steady increase of premium owing to a longer growth track record.

But in the broader market, one can infer that longer time frames of high growth are now being factored to bid-up valuations, going by the high 20 times one-year forward PE multiple for Nifty 50.

The conservative approach should be to pay for only ‘visible’ period of growth. Even the best industry practitioners can only predict the current economic cycle, which lasts between 8 and 10 years. While a longer successful history of India Inc is inducing a higher confidence to discount even 2034 cash flows, buyers should act with pessimism and seek bargains. If there is a tendency to be optimistic, the buyer should take a moment to think why the seller is pessimistic and selling the stock, need for cash apart.

Better investing environment

There are a host of other smaller enablers which are also contributing to high multiples. Incrementally, post-Covid, these unquantifiable markers have played their part in pushing valuations further.

Firstly, the number of demat accounts has grown four-fold from 2020 and today stands at 16 crore demat accounts. The retail participation through mutual fund route has also been equally stellar, with SIP inflows every month growing to ₹21,000 crore  in June 2024, from ₹8,000 crore in June 2020. While valuations are intrinsic, there is a demand pull to the stocks as well.

The enthusiasm  in retail participation post-Covid has also been remarkably consistent . This is reflected in the fact that there has not been a significant dip in the markets in the last four years. While global indices such as Nasdaq and S&P 500 endured a bear market in 2022, the Nifty 50 managed to avoid it . Domestic buying cushioned the FII selling during that phase.

The high demand that is high on enthusiasm is chasing a limited supply of stocks, by international standards as well. As per Bloomberg, India has a free float shareholding of 48.9 per cent as on date (Nifty-50 members) compared to 96 per cent in Dow Jones (US), 83 per cent in Nikkei-225 (Japan), 80 per cent in DAX (Germany) and even Hang Seng’s 58 per cent. This also plays a part in pushing valuations further, especially with high demand.

The macroeconomic factors have improved India’s attractiveness for foreign capital. The contained inflation and growth prospects, alongside structural stability, are driving higher capital inflows. Drawing from the Chinese experience, India’s current per capita GDP of $2,400 is seen nearing the inflexion point of $3,000 from where domestic demand can support a high growth phase to middle-income-status country.

Lessons from the past

The buoyancy in equities driven by lower risk perception, higher growth and other hygiene factors may seem to justify the index trading at 20 times forward PE. But at such levels there is no margin for error in investing to accommodate the unknown risks that frequent markets from time to time and that can have a long-lasting impact.

The Covid impact hardly qualified as a blip in markets as index surpassed previous highs and recorded new peaks. On the contrary, the global financial crisis induced 2008 slowdown persisted for six years as the index peak reached in early 2008 was breached again only in early 2014.

The response to 2008 crisis launched a wave of inflation, which persisted from 2008 to 2014, when it sustained above 6 per cent. The period also saw the banking crisis with twin balance sheet problem of the lender and the borrowers left in shambles for the next decade. A strong dose of recapitalisation to banks has repaired the damage only recently. Private sector has yet to take on capex momentum despite tax cuts and government leads, as it is taking extended lessons from that prior period. On a rolling basis decadal EPS CAGR of Nifty-50 persisted below 5 per cent for the periods 2007-17 to 2011-21, only recently scaling back to 10 per cent.

Such optimism is driving upward revisions in earnings, growth phases and other enablers, and downward revisions in discount rates to meet the sky-high optimism of sellers. Mean reversion of premium valuation multiples from 20 times to 18 times is not without precedent and needs to be monitored. Further, markets, every once in a while, can also trade below mean valuation levels as they have traded above the mean for a few years now. Given these, cautious optimism over unbridled optimism would stand investors in good stead in the current context.