Perspectives on the Valuation of Indian Equities

Date: Nov 2014
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We know so far this year Indian markets have returned about 27% for every dollar invested. Ostensibly a pro-business Govt elected to rule India is the biggest driver of this upward march. It raises a question – how high should we get? Sentiments have ranged from simply feeling good to feeling euphoric.

I reflect on that question here. We conceptualise valuation as a multiple of current earnings of the business. Current earnings are facts and the multiple is hope, indicative of how much earnings is expected to grow in the future. We examine possibilities of high earnings growth by looking into the past.

What’s new about measuring historical earnings growth?

Well, what’s new about examining the past? Experienced analysts do it all the time, but there are two issues that I will overcome here. One, each analyst tends to look at a different stock universe depending on what he covers. When I searched for “earnings growth in the past”, I got no one answer and unable to draw any inference. Another obvious issue is the presence of incentive bias in what the sell side research says and recommends.

To find out past earnings growth I decided to look at a market representative set of listed Indian firms as far back as possible. But a fast evolving capital market means that there is not enough coherent history to extrapolate into the future. The best we can do is to make balanced assumptions that allow us to draw important lessons.

I took a widely used measure of market, CNX Nifty index that comprises 50 stocks representing 23 sectors of the economy. It accounts for 65 % of the market cap of India’s most traded stock exchange, the NSE. I unbundled this index by taking their current constituents (as on early Sept 2014) and looking at their historical earnings growth. However stocks recently listed had to be dropped because the pre-listing information may not accurately reflect the listed entity let alone its earnings. One constituent was dropped because it underwent a major business re-structuring exercise.

This left us with 42 companies accounting for 56% of market cap (Sept 2014) and a period of preceding 10 years (April 2004 until March 2014) to look at earnings.

What was the earnings growth for the 42 in the past?

The 42 firms we examined over a period of 10 years (or 9 years of y-o-y growth) gave in aggregate an annualised earnings growth of 15.3%. This was the period when India’s real GDP grew by 7.6% on average annually, ranging from a high of 9.6% to a low of 4.5%.

15.3% will sound materially lower than what is often quoted in business press or sell side research notes. For instance a leading financial house said in June 2014, “This translates into a 16% PAT CAGR during FY14-16E for our coverage universe, which indicates initiation of a new up cycle in corporate earnings and reversion to the average 17% PAT CAGR witnessed in the last decade” (emphasis mine). Another large asset management company states in its presentation that “From 1991 to 2013 on average Sensex EPS growth has been around 19%”

So why is there a big deviation from Index growth quoted above? Not because of the different time periods considered. It’s because the index constituents change every year and almost always a slowing or falling earnings growth stock is replaced by one that did better. Earnings growth computed thus magnifies the numerator relative to the denominator magnifying growth. As a result the Index earnings growth year-on-year gets exaggerated vis-a-vis growth of its constituents over a period of time.

How much external equity to get earnings growth?

Growing in a rapidly expanding economy may require seeking additional external equity, besides issuing stock options to employees. Such additions dilute per share earnings for a shareholder’s equity prior to the dilution. Thus earnings growth we computed earlier have to be adjusted for such dilutive effect.

The results of such an adjustment exercise are quite revealing. Other than Hindustan Unilever (HUL) and Jindal Steel and Power Limited (JSPL) which marginally reduced their share count via buybacks, nearly all of them increased their equity leading to dilution of share count. Table 1 shows firms that substantially diluted equity.

Table 1

The dramatic impact on diluted earnings growth can be seen with Indusind Bank Ltd. The bank grew its earnings annually by a whopping 23.5% but adjusted for dilution the earnings growth comes down to 15.6% annually.

Research reports talk of EPS growth in their next year forecasts implying dilutive effects have been considered. However neither are they explicit on their assumptions nor do they consider its long term effects.

My calculations show that in aggregate there has been a 7% dilution in equity over the past 10 years. This has had a damping effect on earnings growth of 2.3% annually reducing earnings growth from 15.3% to 13%. In other words adjusted for equity dilution these firms grew their earnings by 13%. Plugging these figures to compute valuations will result in lowering fair value of most estimates.

How did this growth compare with nominal GDP growth?

These firms are larger, more financially sound and efficiently run thus better placed to exploit opportunities in a rapidly expanding economy. So if we expect GDP growth in the foreseeable future to accelerate it is fair to expect them to grow much faster. How much faster? We can get an idea by looking at their growth in the previous cycle relative to GDP. Recall this period saw real GDP growth range from 9.6% to 4.5% averaging to 7.6%. Such an exercise can give fillip to the multiplier of earnings and provides the rationale for many to raise the “target price” for the firms.

Well, much to my own surprise the earnings growth for these firms had trailed nominal GDP growth by 2% as seen below.

Table 2

A possible explanation is that firms increasingly have their fate tied to the global economy. This follows from many global acquisitions like Corus by Tata Steel, Novelis by Hindalco and Jaguar Land Rover by Tata Motors. A deeper implication is that a higher GDP growth may lead to higher earnings growth but there is no positive multiplier effect that boosts earnings by a bigger factor. In other words there may really be no basis to increase an already high earnings multiple in anticipation of higher GDP growth!

But forget the distant future even in this very financial year earnings are forecast to grow modestly by experts (11% EPS growth for Nifty). So holding on to current optimism at a PE multiple of 18 will fetch an investor a modest return of 11% plus dividends.


To sum up – valuations of Indian equities have been on a roll in anticipation of higher GDP growth. But a closer examination of track record of blue chips in the previous cycle shows “markets may be twisting facts to suit theories, instead of theories to suit facts”. A higher valuation from already high levels justified on the basis of anticipated GDP growth appears to have little grounding in facts.