'Is this a good time to enter the markets?' This is probably a question that comes to the minds of investors very often. It would be the case regardless of the market situation - bull or bear. During times of uncertainty, investors would be perplexed by this question even more; as the never-ending search for the market bottom would be on.
Looking at the value of BSE-Sensex in absolute terms makes gauging the attractiveness quite difficult. We believe a good way of doing so would be by looking at valuations.
The chart below displays the index's valuation - P/E Ratio - over the past decade.
Data Source: ACE Equity
As the case has been for a while now, the Sensex is seemingly trading at valuations lower than the long term (10-year) average of 18.6 times (same is the average on removing the extreme 10% valuations - highs and lows - as well). At present, the Sensex's valuation stands at 16.9 times on a trailing twelve month basis.
All eyes on forward earnings
As reported in the Indian Express recently, Indian equity markets are likely to seem cheaper than their long term averages. Why is that? Because of the uncertainty relating to the denominator of the P/E ratio i.e. earnings. As per the business daily, it is the earnings growth which is likely to guide investor interest in the coming future.
As reported, the Sensex was trading at a forward multiple of 12.7 times at the start of the past week. The index closed at 18,358 points on last Monday. The earnings per share (EPS) - arrived at by dividing 18,358 by 12.7 - from a one year forward perspective stands at about Rs 1,445.
As per current value, the index's EPS stands at about Rs 1,110. As such, going by the above mentioned estimate, the analyst community is estimating a sharp earnings growth of over 30% over the next year!
The table below displays the Sensex's valuations a year from now in different EPS growth scenarios (compounded) over the next two years.
Data Source: ACE Equity, Equitymaster Research
What the actual numbers may be are anyone's guess. From the data available to us, the EPS earnings of the Sensex seem to have grown at a compounded rate of about 17% over the past 10 years. We believe this is a fair estimate to go by. In that case the valuation from a one year forward perspective seems to be in the range of 14.1 (taking a 20% CAGR in EPS) to 14.7 times (taking a 15% CAGR in EPS). While these may not seem to be too expensive, we nevertheless believe that the point of taking the earnings growth into consideration as valid.
As our founder Ajit Dayal had highlighted recently, Indian companies have invested substantial amounts towards building up capacities over the past few years. This has been done in anticipation of high demand. A lot of these capacities are yet to come on stream. With a slowdown on an overall level, the possibility of overcapacities does remain. This would lead to eventual lowering of realizations (to fill up these capacities) which would lower margins. Companies' profits would be under pressure due to higher depreciation charges. Interest costs would also stop getting capitalized - due to capacities becoming operational - thereby reflecting in profit and loss statements in the form of interest costs. This would also add pressure to profits.
In any case...
...what the earnings growth for the Sensex would be is something that is not very easy to predict. Investors may see some volatility in the medium term due to factors such as high foreign institutional investors' action, quality stocks being expensive and earnings not meeting expectations, amongst others. But we believe that the valuations of India's biggest 30 companies are somewhere in the comfort zone. The best strategy for investors would be to focus on good companies and acquire them at comfortable valuations. Given that the Sensex is a collection of many stocks representing various sectors, it is not really something that would make sense to ponder over too much.