Are Indian stocks over-valued?

Date: Jul 2009
Published on: http://www.thehindubusinessline.com/todays-paper/tp-investmentworld/article1085591.ece

"They do seem to be, if you go by the historical return on equity recorded by Indian companies and the key drivers of these returns, argues this article" - V. Krishnaraj

In May 2004, soon after Left parties notched up their best electoral performance, the stock indices collapsed by 20 per cent as fear gripped Mr Market. But Mr Market’s fear proved unfounded. Ironically, India turned in one of its best performances in the next five years. The economy grew at 8.8 per cent annually until 2008 and Corporate India recorded high profits and returns on equity.

Mr Market then responded; raising the Nifty fourfold before correcting. What should an equity investor (as opposed to a speculator) make of Mr Market’s wild swings?

We think the investor should believe in Graham’s dictum that in the short run the market is a voting machine, but in the long run it is a weighing machine. The ‘weight’ should be a reflection of Corporate India’s performance, which this article looks at, to peg them to valuations and see if they can be sustained.

Return on Equity jumps

Only the S&P CNX 500 companies, constituting 95 per cent of the market’s total capitalisation, were examined. Then a time horizon of as far back as possible was chosen, with as many stocks as possible. Financial services firms and banks were excluded as their businesses would need to be assesses differently.

This left 228 firms whose audited information was available for 16 years from 1993 to 2008. Investors know that the most appropriate measure of a firm’s financial performance is the return on equity capital; this would be the focus of the analysis.

Think of the return on equity (ROE) as akin to interest payments on a fixed deposit with the principal amount being the equity capital. Both are a return for committing capital. However what is “extraordinary”, as Mr Warren Buffett put it, is that the ROE over long periods remains the same; much like a constant interest rate; it has hovered at about 13 per cent for the US markets. Corporate India’s ROE since 1993 is 18.2 per cent.

The last five years (2003-2008), however, saw a near 50 per cent jump in ROE to 22.8 per cent, providing a strong case for re-rating of Indian stocks! It is, hence, natural to ask if ROE is finding a new mean or is surfing at a crest soon to fall? To understand that, let’s breakdown the Indian ROE, for the two periods 1993-2002 and 2003-2008.

Drivers of ROE

Interest costs fall, lift profits: Accountants will tell you that a higher return on equity has to be driven by three key variables:
  1. A higher net profit margin. This can come from 4 factors:
  2. Higher operating margins
  3. Lower interest rates, and hence interest charges
  4. Lower depreciation charges, and
  5. Lower direct taxes,
  6. Higher asset turnover (Income / Assets)
  7. Higher leverage (including Net Deferred Tax Liability)
An analysis of Corporate India’s numbers shows that the phenomenal ROE expansion was pushed by improvement in net profit margins and higher asset efficiency, even as leverage declined (Table: ‘What lifted ROE’).

Delving deeper into these components, one finds that the record net profits came about mainly due to a dramatic fall in interest charges (by 3.2 per cent), even as operating margins actually decreased in the recent five-year period (Table: ‘What helped net profits’)! Asset turnover improved and income-tax grew on improved profits.

Pepping up efficiency

Moving on to increased asset turnover, it’s interesting to see how firms squeezed extra revenue from assets, even as revenue itself grew by 18.6 per cent. As inflation was lower in this period, most of this would have come through volume growth rather than price increases. To manage higher revenues, India Inc would have had to invest in more capacity, more inventory and receivables. The Table ‘Asset mix’ indicates the following:
  1. The lower net fixed assets and depreciation show that firms added less capacity than earlier for generating the same income. Further, capital work-in-progress, a proxy for capacity addition, fell by 9.6 per cent (as a percentage of NFA) in this period of rapid revenue.
  2. Firms did a remarkable job in reducing working capital needs arising out of increased inventory / receivables. Firms reduced inventory from 65 to 46 days and receivables from 90 to 58 days. Payable days reduced from 48 to 43.
  3. A good amount of retained capital was held as cash and investments. Corporate India’s cash holding went up by 4.7 per cent of total assets.
  4. Investments showed a bigger jump, constituting about 20 per cent of total assets. Less than half the increase went to fund group companies and, hence, can be assumed to be not easily liquid.
  5. High retained earnings led to lower leverage, even as interest rates edged lower.
  6. The net effect of reduced leverage was to dampen the ROE but the increased profit margin and asset efficiency more than compensated for it. To summarise, return on equity, in a high GDP environment, was boosted by reduced interest rates with limited capacity additions and better working capital management.

Will high ROE continue?

As we move from facts to “reasoning out the future” we are on probabilistic ground!

Let us simplify our task to just assessing if high ROE levels of 23 per cent will continue or not. Domestic income growth will likely remain high in a 7-9 per cent domestic GDP environment. However firms, this time around, will have to likely add more capacity per rupee of revenue they want to generate.

With net fixed assets at 55 per cent of assets and capacity additions limited in recent years, this cannot continue forever as capacities will have to be added as well as replaced. This cannot be funded fully by liquid assets.

So Corporate India will have to either issue new equity or debt. While the former will dampen the ROE for existing investors, there is headroom for the latter as the debt-equity ratio is at a healthy 0.56. So, chances are higher that firms will raise debt to add capacity.

Expansion in sales will again put working capital pressures as firms need to keep enough inventory and have more receivables outstanding. Thus, overall asset turnover may be lower.

After-tax profit margins will see more interest and depreciation charges as new capacity gets added and funded by debt. Direct tax charges may come down but the net effect will be to reduce after tax or net profit margins.

Will operating margins improve? Historically, operating margins for India Inc have remained in a narrow band, around 17 per cent, and have never improved consistently.

Based on the above outlook, it appears more likely that the ROE for Indian companies will head lower in the coming year.

However, the biggest wild card could be interest rates. If interest charges shoot up, that may well reverse the expansion in net profit margins witnessed in recent years.

So what about valuations?

Let us run a thought experiment on valuations. Imagine Corporate India converted its current equity capital to an equivalent number of Rs. 100 bonds delivering a 23 per cent interest per year the current ROE, for 10 years.

We assume 68 per cent of the profits are retained (based on historical retention) to add back to the principal each year and assume that these “bonds” are bought back at book value at the end of 10 years. Assuming a risk-free rate of 7 per cent, what then should be the current price of these bonds?

It turns out with some math that the price works out to Rs. 317. That translates into a Price/Book Value of 3.17 for the S&P CNX 500. As on June 17, the S&P CNX 500 had an actual P/B of 3.06.

With the current Price- Book ratio quite close to the computed one, investors can expect more or less the same yield as a risk-free government security (7 per cent) by investing in the S&P CNX 500.

Now repeat the same quiz based on India’s historical ROE of 18.2 per cent. The price drops to Rs. 229, or a P/B at 2.29, against 3.06 currently.

The conclusion is that if Indian companies only manage to register the historical ROE — quite a likely scenario, investors are today over-paying for their stocks by a good margin. A rise in interest rates would only make the equation even less attractive.