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Markets: Valuations. Justified? - Views on News from Equitymaster
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  • Dec 23, 2004

    Markets: Valuations. Justified?

    There seems to be no looking back for the stock markets. While the markets are on a more fundamental footing as compared to the 2000 rally, it is also pertinent to analyse how strong is this footing. In this article, we have a special study of our Quantum Universe of company database. Once again, the results are revealing.

    The table below shows the sectoral gross profit margin and the price to earnings ratio as of FY04 (sorted on the basis of P/E ratio). The number of companies taken into consideration for each sector is mentioned in the first column (total of 143 companies). While the gross profit margin is calculated as an average of all companies from the respective sector, the price to earnings ratio is computed by taking the high and low price of each stock in FY04 (i.e. between April 1st 2003 to March 31st 2004) and then taking the average of all the companies.

    The Quantum Universe - Sorted by P/E*
    Sector - FY04 No of cos GPM (%) P/E (times)
    Shipping 5 36.4 5.3
    Textiles 7 17.0 6.3
    Steel 12 24.0 8.3
    Tyres 4 7.7 8.4
    Energy 12 14.5 8.6
    Auto ancillaries 12 15.0 10.9
    Paints 4 12.0 11.8
    Media 5 24.4 13.2
    Power 4 25.4 14.3
    Auto 10 11.1 14.3
    Cement 6 16.8 14.5
    Software 14 22.2 17.8
    Consumer products 9 16.1 18.0
    Engineering 16 9.6 18.1
    Pharma 19 22.2 25.0
    Hotels 4 22.6 28.9

    With this introduction, here is our view on the data and how investors could use this to take investment decisions in equity for the future. To start of with, despite witnessing record margins in FY04 (the highest among the sectors here), the P/E multiple of shipping stocks is the lowest. There are two factors governing this paradox. One, the sharp rise in freight rates in the global markets on the back of increased demand for crude oil and commodities in FY04 raised apprehensions among investors over the sustainability of the same.

    Secondly, shipping is a highly cyclical sector and visibility in earnings beyond three to six months horizon is very poor and that partially explains the lower valuation as well. The same is the case with other commodity sectors like steel. Typically, valuations of commodity stocks tend to look depressed at the peak of the cycle because earnings growth and margins are at record high levels. Even now, though steel prices are relatively higher on a YoY basis, investors need to keep this factor in consideration while taking investment decisions.

    At the other extreme, hotel stocks were trading at a very high premium in FY04. Though the average gross profit margins at 22.6% in FY04 are still better, the fact that the industry was witnessing a downturn for the third row in a year (atleast for the first half of FY04) affected the financial performance of hotel stocks. Besides, the expectation of sharp revival in international tourist arrivals was (which eventually did happen), also a factor behind this superior valuation.

    On the back of higher infrastructure spending by the government and increased investment in power capacities, engineering stocks were also in the limelight last year. The order book growth of most majors like BHEL, ABB and Engineers India was robust, which in turn did have a positive rub off effect on engineering stock valuations. This rally has continued in FY05 as well. Though prospects are good, investors need to keep in mind that engineering companies do not take orders beyond an executable level and secondly, valuations as compared to some global majors at the current juncture are not cheap by any standards. To that extent, investors could tread with caution. Without going into the details of each and every sector, we highlight below few aspects, which investors could use to take future investment decisions:

    1. Taking into consideration the gross profit margin and P/E multiple averages of the sector, investors could plot the current valuations of stocks from that respective sector to understand if there are any deviations. While a lot has changed in the last one year (the rise in crude prices being the major one), fundamentally speaking, the data is still relevant for taking investment decisions.

    2. Secondly, economy goes through cycles and during periods of faster growth (led by higher volumes and firm prices), valuations of stocks tend to look cheap and therefore, can be misleading.

    3. Though software, engineering, auto ancillaries and auto have witnessed faster growth in profits over the last two years, owing to higher input cost and increased competition, margins may come under pressure in the future. To that extent, the net profit growth may not continue to outpace the topline growth.

    While robust fund flows into the country is driving valuations of stocks to higher trajectory, fundamental factors need extensive study and in the long-term, only fundamentals support valuations. It is often said, "markets can remain irrational longer than investors can remain solvent"



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