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Frontline stocks overvalued? Investors should wait and watch

This article was posted on May 11, 2009 and is filed under Stock Views

There’s no stopping the Indian equity markets right now, it appears. Last week, stocks further extended their winning streak and the benchmark BSE Sensex gained nearly 500 points or 4.2% in five trading sessions ending May 8.

The rally continues to be broadbased as in the previous few weeks. In the past five trading sessions, the Nifty jumped 4.2%, the Nifty Junior went up by 5.2% while the BSE Midcap and BSE Small cap indices continue to outperform the benchmarks.

Obviously, the sentiment is extremely positive on Dalal Street right now. While the bulls are rearing to go, opportunities are shrinking for retail investors with each passing day. Value is evaporating fast. If in early March, most frontline stocks were dirt cheap by historical measures, a majority of them are currently over-valued.

This puts retail investors in a tight spot, especially those looking to use the economic downturn to build an equity portfolio for retirement. ET Intelligence Group looks through the fog at the historical valuations of Nifty-50 stocks and gauge the sustainability of the current rally.

On Dalal Street, the fair value of a stock is typically measured by three variables: dividend yield (in percentage), price-to-book value (P/BV) ratio and price-to-earnings multiple (P/E ratio). Everything being equal, a stock with higher dividend yields and a lower price-to-book ratio is preferable. Similarly, a long-term investor would prefer a company with a lower price-to-earning multiple. The absolute value of the parameter doesn’t matter much though. The key is to compare the current valuations with historical averages.

We have used the three ratios to run a value check on 50 stocks that comprise the NSE Nifty index. For historical averages, we have taken the median value of parameters in the past 36 quarters beginning January-March 2001. This way, we capture both the bear phase (during 2001-03) when stocks were dirt cheap as well as the subsequent Bull Run when valuations scaled new highs. We have omitted Nifty stocks for which the comparable data was not available for a long-enough period, and were left with 41 stocks.

In our framework, 33 out of 41 stocks look expensive. These account for nearly 75% of the combined market capitalisation of all 50 Nifty companies. That’s not a recipe for a sustainable rally unless you are a trader and like to play the momentum game. (The data on all 41 companies is available on www.etintelligence.com)
Many of the stocks are now more expensive than their valuations in financial year 2002-03, the previous economic downturn. Take BHEL, for instance. Right now, it is trading at nearly 29 times its net profit in the past 12 months, an over 40% premium to its long-term average P/E multiple.

The stock is now priced seven times the book value (of its assets), which is more than twice the historical average of 3.2. An investment of Rs 10,000 in the stock will currently earn you a dividend of Rs 90. In the December 2002 quarter, the same investment would have yielded a dividend of Rs 230. At the other end of the valuation spectrum is Tata Steel.

With a dividend yield of around 5.5%, the stock looks inviting at its current price. The euphoria, however, dies down soon enough, when you consider that the stock offered a better yield in 2002-03. Moreover, in 2003, the company had no Corus to worry about. With a higher risk, investors deserve a lower, not higher valuation.

There’s nothing wrong in higher valuations per se. What matters is the corresponding growth in earnings. For instance, a price-earning multiple of 22 is fine for NTPC as long as the company can grow its earnings at 22-25 % per annum on a sustainable basis.

But this is difficult, given its historical performance and nature of the industry. In the past 15 years, the company’s net profit has grown at a compounded annual rate of 15%, which is close to its historical average P/E multiple of around 17.

The analogy applies to most leading stocks right now. In a majority of cases, valuations are running ahead of fundamentals. Given the state of the economy and the demand conditions at home and overseas, it will be an uphill task for India Inc to meet market expectations in the forthcoming quarters. And everyone knows what happens to stock prices when companies fail to meet the Street’s expectations. So to those of you who have missed the bus, it’s advisable to stay out for the moment. The current momentum may take the market to a new high, but the reversal could be equally sharp.

source: Economictimes

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