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Stocks: What's the earning power?

Jul 6, 2005

There was some correction witnessed in the markets yesterday after it, once again, created record highs (the BSE-Sensex breached the 7,300 levels). While this surely would not have given the creeps to the bulls who have now been seemingly eyeing the 'next high' and are very much used to taking the 'healthy correction' in their stride, it is the retail investors who share the higher risk as, intentionally or unintentionally, most of them are invested in the not-so widely tracked mid-cap segment. Leave alone this, many of them would be over leveraged and as such, they are sitting on a ticking time-bomb, which may go-off sooner or later. While we are not trying to scare investors away from equities, what we are trying to highlight is the fact that the risk-return ratio currently does not favour going overboard on equities. You never know when the tide might turn!

Given below is a table wherein we have tried to find the major tops and the bottoms of the Sensex over the last decade, which is primarily to get a feel of what corrections are like. And as can be seen, the hit has been really hard on most of the occasions!

Earning power of the Sensex
  Sensex % change Earning power
December-96 2,713 - 9.1%
August-97 4,605 70% 6.0%
October-98 2,741 -40% 10.0%
February-00 6,151 124% 3.9%
September-01 2,595 -58% 7.4%
January-04 6,250 141% 5.0%
May-04 4,228 -32% 6.8%
March-05 6,955 64% 6.0%
April-05 6,118 -12% 6.8%
July-05 7,220 18% 6.3%

However, while absolute index levels do not make sense, we delved a bit deeper and got hold of the P/E multiples of the Sensex on these occasions i.e. when the markets were at the top and the bottom. After that, we inversed the same to arrive at the 'earning power' of the Sensex, the results of which can be seen in the table above. What caught our eye was the fact that every time the earnings potential of the Sensex breached a certain level the markets would go into a correction mode. Now, we are not being technical here but instead are trying to infer something of the above table.

'Earning power' is basically what the Sensex (or its constituents together) would return under normal circumstances. Thus, at a P/E multiple of 10, an investor would recover his investment in 10 years and can thus expect a 10% per annum simple rate of return. However, when this multiple is higher, say 16, the same amount of investment would be recovered in a period of 16 years, which translates into a simple interest per annum at 6.3%. This 6.3% return is then the earning power of the said investment.

But isn't the 10-year G-Sec yield currently trading at about 7% p.a. or wouldn't an investment in the National Savings Certificate (NSC) or the Public Provident Fund (PPF) fetch you an interest of 8%? And of course, not to forget here is the most important fact that these investments are 'risk-free' by virtue of the sovereign backing. Then what sense does it make to invest in equities when its earning power is nearly 6.3% (considering Nifty's trailing 12-month P/E of 16)? Shouldn't an investor be earning higher for the extra risk that is being taken by investing in equities?

Now, at this juncture, some may argue that investing in equities is about future earnings potential. Very true! So, let us consider that the Sensex companies' earnings would grow at 17% per annum over the next couple of years, which is a reasonable assumption considering the track record of the past decade. Thus, FY07 P/E multiple works out to under 12 times earnings, which implies a much more reasonable earnings power of 8.6% per annum (1 divided by 12). But then, this is precisely the fact that we are trying to make here. The markets seem overvalued from the medium-term perspective.

However, while staying out of equities would not be the right thing to do (as the inherent risk in equities reduces in the long-term), stock picking is an absolute must at the current juncture. Also, a good mix of different types of investments is the primary need of the hour.

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