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August 18, 2000
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Home >
Money > Columnists > Devangshu Datta August 18, 2000 |
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The P/E ratio through two decadesOnce upon a time, not so long ago, newspaper editorials would warn everyone about the risks of overheating and excessive speculation every time the Sensex price-earnings multiple (P/E) hit 10. In 1990, for example, when the market index hit the dizzy heights of 1,000 points, there was much dire warning about the sustainability of a 15 P/E, which was the market discounting at that point. It so happened that the Sensex had never come within touching distance of 1000 points again. Less than a decade later, predictions that the current bear market might correct down to Sensex P/E discounts of 20, arouses cries of universal derision and accusations of pessimism. A P/E of 25, which is the approximate discounting at a Sensex of 4300 points, is considered a sustainable market bottom by the majority of participants! What happened? How and why did a market that traded at single digit P/Es through the 1980s suddenly see an extraordinary explosion of valuations to 25? Was the rise in valuations justified and what did it do to returns? L C Gupta (who was assisted by Utpal K Choudhury) of The Society for Capital Market Research and Development tackled several of these questions in his July 2000 book Returns on Indian Equity Shares. Gupta came up with some interesting insights and answers and placed two decades of market change in perspective simply by a set of far-reaching statistical studies. First and foremost, there was indeed a huge change in equity valuations after 1991. Between 1979-80, (the base year of the Sensex) and 1989-90, the market's average P/E ratio fluctuated between 6 and 14. Between 1990-91 and 1999-2000 (the study only covers 1998-99, but we can add the last fiscal in hindsight) the P/E has usually ranged between 12.5 and 40. That is one hell of a jump. Yet there is continuity in that Gupta and Choudhury dealt with upwards of 350 companies every year through this period to generate their data. Many of those companies are still very much in business. Dr Gupta suggests that a part of this rise in valuations can be explained by the entry of foreigners and the development of an equity cult. Demographic change in the form of a new middle class and the greater penetration of mutual funds after the 1993 explosion also undoubtedly made a difference. But there is more to it. One underlying reason is psychological. A lot of people seem to have intuitively realised that equity could generate real returns when no other asset would in an atmosphere of uncertainty. Interest rates and currency fluctuated more between 1990-2000 simply because they were no longer completely mandated by the expectations of faceless officials. If debt becomes risky, you may as well plump for the extra rewards of equity. The delivery of transparent paperless trading systems, and the drops in spreads and brokerages also helped pull in investors. Another psychological reason is that investors learnt to treat Indian equity the way Americans deal with junk bonds after Mike Milken. Sure there will be defaults, some companies will disappear without forwarding addresses. But on balance, the returns outweigh the risks. There will also be multi-baggers that will drag every reasonably diversified portfolio above returns from other investment instruments. But the biggest fundamental reason for higher valuations was that the rate of corporate growth accelerated sharply for good businesses. Price-earnings ratios are (presumably) related to expectations of higher earnings. Between 1979-80 and 1989-90, the earnings pattern was barely positive after factoring average inflation in the 8-11 per cent range. The next decade saw a clear inflection point in the form of liberalisation. Using a weighted mean (by market capitalisation), the Sensex earnings per share (EPS) grew by 12 per cent between fiscal 1980-1990. Between 1990-1999, it grew at 18 per cent compounded. The general portfolio of 350-odd companies that the study examined across this period showed similar results. The EPS grew by 16.8 per cent between 1980-1990 and by 20.75 per cent between 1990-99. Obviously market freedom was an accelerator for various companies and since the weighted EPS growth was higher than the unweighted, the environment favoured companies that already achieved a certain size. So did the market, since the valuations of outperformers went up sharply, increasing their market cap and dramatically improving the weighted returns. (For the purposes of the study, market cap was calculated at the beginning of each fiscal). No matter how imperfect the market, capital will always gravitate to a more attractive return. That happened as equity caught on. Higher valuations are certainly justified by higher rates of return in the form of quicker EPS growth. Interestingly, the research also suggests that the Indian markets conform to other rules of financial economics. The general portfolio shows higher fluctuations. Returns are higher, so are risks. The general portfolio returned between plus 140 per cent and minus 30 per cent on a year-to-year basis. The Sensex returned between 117 and minus 20 per cent in the same period. All Sensex returns for holdings over a decade were positive, and similarly for the general portfolio after eight years. The reward-risk equation should indeed be higher for smaller companies for a host of reasons. The reason is simple: little is known about them, they can grow quicker as their base is smaller and they have smaller reserves both to ride out recessions and exploit new markets. The sudden rise in valuations may have completely skewed returns for statistical purposes. Investors who got in earlier at 1980-90 P/E levels got abnormal returns almost automatically because the valuations rose. To state it another way, the market was undervalued for the entire decade. In the high P/E years of 1991-99, the unfortunate ones, who bought during the bull markets of 1992, 1994 and 1999, suffered losses. Those who bought during the bear markets (1993, 1997, 1998) did well. Since we cannot expect a drop back to pre-liberalisation valuations, the abnormal returns between 1980-2000, may now be a thing of the past as the authors suggest. This forces the long-term investor back into discriminatory well-timed buying during periods of undervaluation. That will probably be the paradigm of the 2000s, with the occasional lapse into bubble mania.
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