The price to Earnings (PE) ratio has been the most widely used measure to assess or compare the valuation of a company against its peers or the overall markets/indices. It has been used as an easy reference by the analysts on business channels to assign a ‘cheap’ or ‘expensive’ tag to a company. In simple words, it is a measure of how much the traders/investors are willing to pay against the Earnings per share (EPS) of a company. EPS reflects how much profit per share is being generated by a company. As an example, the company in which investors have to pay 10 times the EPS would be cheaper than another one in the same sector where they will have to pay 30 times the EPS. These two measures can also be used to assess the valuations of the overall market or an index. This can simply be done through a comparative analysis of the historical data available for the above two variables.
The year 2020 not only faced a huge market crash of about 40% from the January highs but also a V-shaped recovery which is still continuing in February 2021. This Northward trend in price has led to a steep rise in market valuations, that is PE. We know that PE is a factor of ‘current price’ and ‘EPS’. If the price has been skyrocketing with constant EPS, the valuations will reach the upper end. THE average PE of Nifty for the last 15 years comes at around 22 whereas in January 2021 it was 38, which is extremely high. Most analysts were of the opinion that better December quarter earnings will revert back the valuations to their mean range and there was nothing wrong with that premises until results actually show up.
Till date, 16 out of the top 20 companies with the highest market cap in Nifty50 have announced their results. These 16 companies account for 64% of the entire market cap of Nifty50. Out of these 16 only five, namely Reliance Industries, Tata Consultancy Services, HDFC Bank, Infosys, and Hindustan Unilever weigh 38% of the entire Nifty50 market cap. Although the majority of the 16 companies have delivered positive growth in earnings yet Nifty PE managed to wriggle up to 41.
It is worth mentioning here that 12 out of these 16 companies have shown a positive net profit in Q3FY21 compared to Q3FY20 (QoQ). All the 12 companies have shown an impressive QoQ growth of more than 15%. Seven large caps, namely Asian Paints, HCL Technologies, Infosys, Larsen, and Toubro (L&T), Maruti, TCS, and Ultratech Cement, have given a spectacular jump of 20% in QoQ net profits. Ultratech cement has a 141% jump in QoQ net profit followed by Asian paint with 56.5%, L&T (39.3%), and HCL Technologies (38.9%). On the flip side Axis Bank, Bharti Airtel, Reliance Industries, State Bank of India are the four large caps that have shown negative QoQ growth in December.
On the valuation front, Axis Bank is the most expensive in the above lot of 16 companies that have announced their results till date. It has been trading at a PE multiple of 90.2 whereas the sectoral PE multiple is 33. It simply means that investors have been paying 3 times more than the sectoral average and that too when the company has an EPS of just 3.6 in the recent quarter and negative QoQ growth of -36.4%. Its peers such as HDFC Bank and ICICI Bank have been trading at a PE multiple of 29.1 and 35.5 respectively and both of them have a QoQ net profit growth rate of more than 15%.
Contrastingly, L&T and Maruti are cheaper when seen through the lens of sectoral averages. L&T has been trading at a PE of 19.2 compared to a sectoral PE multiple of 52.1 and Maruti has a PE multiple of 52.9 whereas its sectoral PE is 254.8. Both the companies have shown a positive trend in QoQ net profit of more than 24% which is commendable.
In this backdrop its can be said that most of the large cap companies have been presenting a good show in Q3FY21. Thus the denominator of the PE fraction of Nifty50 has shown growth on expected lines. But unfortunately Nifty50 is still trading at expensive valuations of 41.4 as on 5th Feb 21. This is possible only when the numerator, that is ‘price’ has been witnessing a parabolic trend. It implies that Price is leading way ahead Nifty50 valuations. The investors who used to pay 21.4 rupees are now paying 41.4 rupees, which is 93.4% higher than the average. Even On YoY bases, markets look expensive. Nifty50 has an EPS of 360 rupees and a PE multiple of 41.4 on 5th Feb 21 compared to EPS of 447 and PE 27.0 on the same date a year ago (see chart).
There is also a contrarian view in the markets. It asserts that companies have still been improving on earnings front and this trend will pick up further in the coming quarters. There is still need to analyse the earnings on a YoY basis after March results, to come at a valid conclusion. If the companies come up with strong revival, then valuations may come in line with the historical average.
So will it be prudent to wait for the markets to correct up to an acceptable PE multiple before fresh investment or is there still some juice left in the current rally? That would be a million-dollar prediction. At this point I can only say that ‘hold’ will be a good strategy for existing positions and ‘caution’ for fresh investments. Also there is nothing wrong in protecting some of the gains, if there are any, on existing positions.