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Earnings versus Valuations: The Dichotomy
Mon, 5 Oct Pre-Open

From a fundamentals point of view, there are two key factors that drive stock prices. One is change in earnings. This would mean the stock price going up on account of increase in earnings. The other factor that drives stock prices is expectations. For example, an expected recovery in earnings in the future could boost stock prices in the present.

If you were to account for the bull rally that corresponded with Modi's coming to power in 2014, the reason was clearly the latter. Hopes of economic revival and the prospects of better growth and earnings pushed stock prices higher.

Factors such as declining global commodity prices, lower interest rates following RBI's rate cuts, and the expectations of key economic reforms were expected to be the key drivers of growth and earnings for India Inc. But if you look at the performance of companies, the earnings are still dismal.

Here are some interesting statistics that we came across in The Economic Times:

On the one hand, the current trailing price to earnings (P/E) multiples of 121 out of BSE 200 companies are above the levels witnessed five years ago in FY11. On the other hand, the net profit of one out of every three companies in FY15 was lower than what it was in FY11.

In other words, while the valuations of companies have gone up, the earnings have actually come down.    

Of course, it is important to understand that stock markets tend to discount future earnings. So the current valuations are not based on the recent earnings performance but on what is expected a couple of years down the line.

Remember that stock prices do not reflect realities but probabilities and expectations. If you factor in too much optimism too far into the future, you are treading the path of uncertainty and speculation. So, the key is to not overpay for a distant promise. And lastly, keep a tab on the ground realities. Over the long run, stock prices are driven by actual earnings alone.

For information on how to pick stocks that have the potential to deliver big returns, download our special report now!

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