“A cloud does not know why it moves in just such a direction and at such a speed, it feels an impulsion…this is the place to go now.
But the sky knows the reason and the patterns behind all clouds, and you will know, too, when you lift yourself high enough to see beyond horizons.”
A quote by Richard Bach
The market valuation is a topic which creates a great divide among the academician, practitioners, and investors. The market is a collection of a great number of companies, engaged in a different sector of the economy, having different financial size and their business cycles are not calibrated. We all know the stock market does not follow a pattern, the stock price movement is random and still, we want to put a number to summarise it.
Valuation is not about pricing and certainly not about market timing. But it’s equally true whatever is valued can be priced and vice versa. And the price is a factor of value and time. Valuation multiples tell you a story in numbers and how you interpret it is certainly up to you.
The valuation multiples what we are going to discuss in this blog are well-known and you will find plenty of reading materials over internet and publications. The idea of this blog is to summarise those ratios in the context of Indian stock market.
PE ratio is simply price divided by earnings. There are a number of ways to define the ratio. It is all based on how the price and earnings are defined. Here, we defined the price as the current price of BSE Sensex and Earnings as the weighted EPS (earning per share) of the Sensex companies in most recent four quarters. Thus the ratio we are talking about is better known as trailing PE ratio.
The PE Ratio is the first and still the foremost valuation tool. The history of PE is as old as that of the markets. When the first stock exchange starts working, the market PE multiple was born. PE is based on the present value of future cash flows from companies. In non-financial terms, the inverse of PE is earnings yield, the amount you are expected to receive by investing Rs.100 in the market. Higher the PE ratio, lower the earning yields.
When we look back across the last three decades of BSE Sensex, we see a rollercoaster cycle of the market PE—vacillating from peaks above 50 in during Harshad Mehta time to troughs just above 10 in October 1998. Since stock price movements are random hence PE cycles are not symmetrical, but they are pronounced and recurring. One aspect is very clear higher the PE; lower will be the forward earning. Historically, the cut-off is 23x, beyond that even your 3 to 5 years forward returns is very dismal.
Price-to-Book Value Ratio
Price to book value is a financial ratio used to compare a company’s book value to its current market price. The book value of an asset is the value at which the asset is carried on a balance sheet and calculated by taking the cost of an asset minus the accumulated depreciation. Book value is also the net asset value of a company, calculated as total assets minus intangible assets (patents, goodwill) and liabilities.
Value investors were always looking for low P/B ratio. Low P/B ratio not only shows low valuation but together with Return on Equity (ROE) become a potent indicator of market valuation. The ‘B’ in P/B ratio and ‘E’ in RoE are the same. You can calculate ROE by dividing net income by book value.
Return on equity (ROE) is one measure of how efficiently a company uses its assets to produce earnings. The high P/B ratio does not necessarily indicate high ROE but on an index level, the weighted average value shows a positive correlation.
A market with a high P/E and a low P/B would be a rare combination. On an aggregate basis, the book value of the Sensex companies has risen almost twice since March 2010, whereas the total earnings of the Sensex companies have risen by only one-and-a-half times. It shows the credibility of Indian market and Economy among knowledgeable investors is high and that increase its stock price before this is reflected in quarterly earnings reports. This somewhat strange combination of ratios may indicate a still undervalued stock in the Sensex that will enjoy a substantial price run-up going forward.
The Bond Equity Earnings Yield Ratio (BEER) is a metric used to understand the relationship between bond yields and earnings yields in the stock market.
BEER = Bond Yield / Earnings Yield
Bond Yield is the yield of 10 years G-Sec and Equity yield is the inverse of the Sensex price-to-earnings ratio.
The thumb rule is to invest in stocks when BEER is less than 1 as equity yield is more than bond yield. Similarly, if BEER is more than 1, invest in bonds. Thus, a BEER of one would indicate equal levels of perceived risk in the bond market and the stock market.
The Bond Equity Earnings Yield Ratio above 1 is not necessarily because of low earning yield from equities, it might be because of high bond yield owing to high inflation and other macro factors. In the Indian context, the bond yield is always higher than the equity yield except during the period 2002-04 and briefly in Oct 08-Apr 09, and we all know what phenomenal returns it has generated thereafter.
The high bond yield is not just an Indian phenomenon, even in the US from 1982 till 2004; the US bond yield was above the earning yield of S&P 500.
Market Cap to GDP ratio
Market Cap to GDP ratio was made famous by the legendary investor Warren Buffet. According to him, it is probably the best single measure of where valuations stand at any given moment.
This ratio in the Indian context is very nascent. Though the Bombay stock exchange has published market capitalization data since FY 2001-02 it was just end of the year value. The monthly/daily data was published only from FY 2013-14. Similarly, the quarterly GDP data is only available from FY 2004-05.
It is assumed that the price movement of stocks reflects the future earnings of the companies. Similarly, consolidated earnings of the companies reflected in the growth of country’s GDP. Hence this ratio gives an indication whether the stock market is running ahead of the curve or it is lagging behind. The fair value of this ratio is one. Any value near one is considered to be fair value.
The average value in last 15 years is 75 pct and in last ten years, the market remains in the 60-100 pct band.
The major criticisms in using these multiples for valuation of a stock, asset or market are:
- They are too simplistic and they hide more than what they divulge.
- There is no standardization. It is defined in different ways by different users.
- The numerator and denominator are not at the same time and space. Though price data is recent there is at least a lag of a quarter in earning, book value and GDP data.
- No multiple captured all the four prime factors – Price, earning, interest rate and inflation.
- These multiple are relative in nature and it has to be interpreted not with its own historical value but also in relation with other macro factors especially the fundamentals which drives these multiples.
As we said in the beginning, Valuation multiples tell you a story in numbers and how you interpret it is certainly up to you.
Lastly, as Burma born British writer H.H. Munro, better known by his pet name Saki, in his short story “Clovis on The Alleged Romance of Business” has said, “a little inaccuracy sometimes serves tons of explanation”.