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Fundamental Analysis: Analysing Nifty Historical & Current Valuation

This is the last article on the Market Valuation series. In the first article, we covered the Basics of Market Valuation and explained about ratios such as P/E, EPS, PB etc. In the 2nd article, we learnt how to Interpret these Valuation Ratios and how best it can be put to use.

In this final article on valuation, we will apply the P/E ratio on the Nifty index to understand how the valuation has changed historically and analyse the current valuation (as on 27th December 2020). The reason why we are applying P/E on Nifty 50 is, firstly P/E is the commonly used valuation metric used in the financial markets, hence a discussion on it can be easily understood. Secondly, Nifty 50 is taken as a benchmark for the high performing companies in the vast Indian equity space. At this point, a lot of scepticism would creep in from the readers, that Nifty 50 is not a right benchmark to use, since the broader market is where we search for future out-performance. So, we will also take the Nifty 500 to compare the valuation curve over time. That should bring a fair inclusion of the broader market into the topic.

Setting The Context

While looking out for historical P/E & EPS data, I stumbled upon a FinTech website which provided excellent references for the historical data. You should check out the website too!

Now, before moving on, let’s recollect some important things about the P/E ratio. P/E is a function of Price and Earnings. Generally, the equity price appreciates in advance, expecting future earnings (EPS) growth. Thus causing the P/E ratio to expand prematurely, making the market overvalued. Once the earnings eventually increase, P/E eases and reverts to the mean or the historical average. But, if the earnings do not increase as expected, the equity price will fall sooner or later to bring the P/E ratio back to normalcy due to dampened animal spirits in the market.

Historical Nifty Valuation

Nifty 50 P/E progression has been steadily trending higher and this is evident when you check the graph below.

Nifty 50 P/E Max Period
Nifty 50 P/E Max Period

The graph captures P/E from 2003 till Jan 2020. Year 2020 has not been considered in this graph because the year has been crazy and completely distorted to have any comparison with historical progression. Hence, we will review 2020 with respect to the recent past later in the post. For the large part, we can notice that Nifty 50 P/E’s mean itself has been on the rise gradually. In the 2000s, P/E was ranging around 18, peaking at 28 in Jan 2008 before the sub-prime crisis. Over the next 5-6 years, P/E was averaging at 20. But in the last 5 years, Nifty P/E was significantly higher above 25 levels. Hence as a continuity, we should expect the mean P/E ratio to expand marginally and slowly. However, in spite of an increase in mean P/E as decades pass, during a period of rapid expansion of P/E, the ratio runs much ahead of the mean. Under such conditions reversion to mean should be expected.

We know that P/E is fundamentally ruled by earnings, so let’s look at how EPS has grown during the same time period.

Nifty 50 EPS Max Period
Nifty 50 EPS Max Period

Nifty 50 EPS (Earnings Per Share) has grown steadily over the same time period. During the period after the 2008 recession and till 2015, Nifty 50 companies performed well and EPS growth was good. But since then, the top 50 companies have been consistently under-performing with respect to EPS growth. At the beginning of every year, brokerages and credit rating agencies estimated optimistic figures for future EPS, but each year, the Nifty 50 companies failed to match the past performance. Asset prices in the aftermath of the recession were boosted by the global liquidity due to the Central Bank’s Quantitative Easing. And for the period between 2015 and 2020, even with earnings growth almost flat, equity prices were rallying leading to an increase in P/E. This can be pictured better when looking at both P/E and EPS plotted side by side as below.

Nifty 50 EPS-P/E Comparison Max Period
Nifty 50 EPS-P/E Comparison Max Period

The chart plots both EPS and P/E and is zero-based from the beginning of 2003 and is represented as an absolute percentage increase. It gives a clearer picture of now EPS and P/E are inversely correlated. The good earnings growth seen until 2015 had kept Nifty P/E valuation in check. In fact, the steeper rise in EPS during 2010 to 2015 made the index valuation low, which set the foundations to the longest Bull run supported by the optimistic view of the analysts. Keep a note on how EPS as a percentage has grown vastly in comparison to P/E growth as a percentage during this period. It is fair to say that earnings was the primary source of strength for the markets.

Recent Valuation, Covid Impact & Liquidity

To judge the current trend, we will zoom in to the last 5 year valuation including the Covid period. In the below graph, P/E and EPS are plotted as absolute percentage increase by setting 2015 as the zero-base.

Nifty 50 EPS-P/E 5 Year Comparison
Nifty 50 EPS-P/E 5 Year Comparison

Surprisingly, now you could notice a major shift in what is driving the market valuation. The role of EPS and P/E has completely interchanged between the long term chart and the 5 year short term chart. EPS growth is subdued and is no longer driving the market. Rather, equity prices are jacked up by global liquidity. EPS growth has been more or less flat for the last 5 years! Yet, P/E kept trending higher. This could only mean that, the hopes were kept higher about an earnings recovery for the past 5 years, which actually didn’t materialise. The higher equity prices due to increased liquidity in the financial markets have already taken P/E ratio to historically higher valuation by 2017 itself.

Even though a marginal improvement was seen in EPS growth since mid 2017, Covid gave a brutal blow to earnings in 2020, which caused EPS to plunge back to negative territory (contraction as compared to 2015 EPS levels). As the stock market crashed in Feb-Mar 2020, causing P/E to spiral down, the asset prices recovered in no time, thanks to the extraordinary liquidity gushed in by the Central Banks across the world, like never seen in history. The liquidity along with retail investor’s frenzied accumulation has sky-rocketed asset prices. Thereby the P/E valuation has risen above 37 as on Dec 27, 2020. All the while, Nifty 50 EPS is still tottering below 2015 levels and yet to fully recover. Given that the market's valuation was already stretched even before the Covid crash, the Central Bank interventions has ballooned the valuation much further up.

Nifty 50 doesn't cover the broader market, hence we should also take a look at the Nifty 500 valuation to make a fair judgement. The below chart plots P/E and EPS for the same time period for Nifty 500.

Nifty 500 EPS-P/E 5 Year Comparison
Nifty 500 EPS-P/E 5 Year Comparison

The story is not much different for this index too. Though EPS seems to have been increasing at a better rate than that of Nifty 50 as a percentage, the P/E ratio has still out paced EPS growth. Which means, asset prices have rallied without sound fundamentals. So, its safe to assume that even the broader market is going through the same cycle.

Is Current Market Valuation Justified?

To conclude the topic, we need to ask, how justified the current valuation is?

The answer given by most market analysts, brokerages and credit rating agencies is that the market has rallied ahead, anticipating EPS out-performance. As evident from the recent 5 year P/E-EPS chart, this answer looks to be standing on shaky foundations. Why? There are multiple reasons for it.

  • Firstly, there is hyper-optimism about EPS out-performance, similar to the past. As data since 2015 has proven, the end result of each passing year was a disappointing EPS growth that couldn't match the optimism.

  • Why would EPS suddenly out-perform from 2021 onward? If one has to be frank, there is no definitive answer for it. The most reasonable answer is India's Growth Story. Though this could very well come true, this is something which is complicated due to actual implementation of Govt policies, easing of the pandemic and more importantly, return of public demand. All these factors are dynamic and cannot be accurately predicted. The future EPS growth outlook is currently fogged and too early to conclude out-performance in future.

  • It is also a question of EPS recovery vs EPS growth for the next 2 financial years at minimum. From the chart, its clear that we are not yet back to EPS levels of 2015 yet. Meaning, whatever improvement we see in earnings is actually a recovery and not a growth. Only after a recovery is complete, the real growth can pick up, which, as mentioned above, could take more time.

  • Then there is the important consideration to make regarding the past few year’s EPS trajectory. Coming into Covid, we had a flat EPS growth, so after the impending earnings recovery, what is the guarantee that we could see a phenomenal EPS growth as opposed to a flat EPS curve of the past?

  • Due to the low base effect of Covid-hit EPS in 2020, we would surely see a pseudo out performance in growth in 2021. But, honestly, that cannot justify the pace and magnitude at which P/E has expanded.

It is evident that the breakneck pace at which P/E has recovered over the past few months is unhealthy. Like mentioned earlier, the P/E ratio will revert to it's mean either with asset prices undergoing significant correction or due to earnings expanding like never seen before. The former is more realistic than the latter. Current valuation is unsustainable until the market comes back to its senses that we might not see the earnings growth promised by analysts.

It is futile to guess when such a correction could occur and the valuation could remain too high for too long. As long as the Central Banks keep liquidity high using QE as a policy, the market can keep expanding P/E irrationally. Hence riding the current bullish trend cautiously is recommended, but we must be highly agile to trim the equity portfolio swiftly once the market begins to show signs of a corrective structure. Keep in mind that at current valuations, you are now paying almost twice of what you should actually be paying. Change in valuation changes the risk profile. Newer investments come at much higher risk than the past. The market's risk profile has changed, so should yours.


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