Is the Indian Stock Market Overvalued?

Is the Indian stock market overvalued?

In May 2004, soon after the left parties botched up their best electoral performance, the stock market index collapsed 20% as fear gripped the market. However the fear subsequently proved futile, and the market then delivered one of its best performances for the next five years. The economy grew almost at 9% and corporate India recorded high profits and return on equity. In fact, the market moved up almost 4 fold before it fell due to the macro economic conditions globally.

To study the current state of the economy, if we were to examine the S&P CNX 500 companies, constituting 95% of the market’s total capitalization with a time horizon as far as possible, firms delivering financial services, and banks, should be excluded as their businesses naturally need to be assessed differently.

Hence, we are left with the remaining 230 firms, whose audited information is available for 16 years - from 1993 to 2008. The best way to judge their financial performance is to assess their return on equity capital, which is going to be the focus of our analysis, because it is a common parameter that can help judge and compare across various sectors and industries, irrespective of their diverse natures.

Simply put, Return on Equity (ROE) can be compared to the interest payments on a fixed deposit - with the equity capital being equivalent to the principal payment of the fixed deposit. Both are simply a return for committing capital over a long period of time.

ROE for the period mentioned above and with respect to the 230 non-BFSI companies, was around 18% for India, compared to that of the US which was around 13%.

In the last five years (2003-2008) ROE saw a jump of nearly 50% (over the 1993-2002 period), to 23%, providing a strong case for re-rating of the Indian stock markets. Hence to understand this re-rating, we need to first figure out whether the ROE is currently finding a new mean, or is only surfacing at a crest soon to fall.

To understand this, we shall break the total time period into two parts viz. 1993-2002 and 2003-2008.

Let’s first take a look at the three key drivers of ROE:

1. A higher net profit margin:

This can come from 4 factors:

a) Higher operating margin

b) Lower interest rate, hence interest rate changes

c) Lower depreciation charges and

d) Lower direct taxes

2. Higher Asset Turnover (Income/ Assets)

3. Lower Leveraging

An analysis of corporate India’s numbers shows that the phenomenal ROE expansion mentioned above was pushed by the improvement in its net profit margin, as well as its higher asset efficiency, even as the leverage declined. Details are as follows:

What lifted ROE

Particulars	1993-2002	2003-2008	Change
ROE (%)	15.4	22.8	48.05%
PAT/Sales (%)	6.3	8.5	34.92%
Asset Turnover (times)	1.2	1.6	33.33%
Leverage (Times)	2	7	-15.00%

What Helped Net Profits

Particulars	1993-2002	2003-2008	Change
Operating Margin	17.2	16.5	-4.07%
Interest/Sales	5	1.8	-64%
Depreciation/Sales	3.9	3.2	-17.95%
Income Tax/Sales	1.9	3	57.89%
PAT/Sales	6.3	8.4	33.33%

It can be observed that the major drivers of net profits during 2003-2008, were in the form of:

a) A fall in interest rates almost by 4-5%, and

b) Decrease in overall leveraging by 15%,

which both contributed to a sharp decline (64% decline) in absolute interest payments in value terms relative to sales. So beneficial was this drop in interest rates for corporate India, that it offset the substantial increase (57.9%) in tax payments as well as a slight fall in operational efficiency (4.07% decline,) to increase the overall PAT/ Sales ratio by almost 35%.

The asset turnover ratio during the second time period also showed an increase of 33.33% vis. a vis. the first time period, while the Depreciation/ Sales ratio showed the same movement (reduction) by a good 18%, and all these factors put together prompted an overall increase in ROE for the second time period by almost 50%.

Pepping up Efficiency:

Analyzing the increased asset turnover ratio, it is important to note how firms squeezed extra revenue from assets. Revenues themselves grew by 19%, and as inflation was relatively low between 2003 and 2008, most of this 19% increase would have come from volume growth rather than price increase. In other words, to have managed higher revenues, India Inc would have had to up production to support the volumes required for the 19% increase in revenues, which therefore translates into increasing capacity, and better inventory and receivables management. Which in turn proves that to have managed such an increase in the asset turnover ratio on the back of an increase in the asset base, was quite a feat performed commendably by corporate India between 2003 and 2008.

Let us take a look at the changes in the Asset Mix for these two time periods

Particulars	1993-2002	2003-2008	Change
Net Fixed Assets	62.10%	55.70%	-10.31%
Investments	10%	19.90%	99.00%
Net Current Assets	27.90%	24.40%	-12.54%

The lower Net Fixed Assets as well as Depreciation/ Sales Ratio, indicate that the firms added less capacity than earlier for generating the same or higher income. Further, Capital Work in Progress, which is a proxy for capacity addition, fell 9.6% in the second period, the period of rapid revenue.

Firms did a remarkable job in reducing the working capital needs arising out of inventory/receivables. Across the industry the firms reduced their inventory from 65 days to 46 days and receivables from 90 days to 50 days.

A good amount of retained capital was held as cash and investments. Corporate India’s cash holdings went up from 4.7% of total assets. Investments showed a bigger increase in the chunk of the asset mix pie, constituting about 20% of the total assets. A large part of this increase went to fund their group and associate companies, and hence may not be termed very liquid.

Higher retained earnings led to lower leverage, even as interest rates edged lower.

The net effect of these two was to substantially increase the ROE as Interest/ Sales dropped, and the increased profit margin and asset efficiency only added to the happy ending.

To cut a long story short, the ROE in a high GDP environment was boosted by reduced interest rates, practical amounts of leveraging, limited capacity additions, improved asset efficiency, and better working capital management.

Will Higher ROE Continue?

The biggest question that needs to be answered is whether the high ROE levels of 23% will continue or not. The GDP is poised to grow at a rate of 7-9%; however, firms this time around will have to add more capacity per rupee of revenue that they want to generate, due to the comparatively higher interest rates currently prevalent, that lead to an increase in the overall costs of capex and working capital.

With net fixed assets at 55% of total assets, and capacity additions limited in the recent years, capacities will have to be added as well as replaced. This cannot be funded by liquid assets. Hence corporate India will have to use fresh equity or debt to fund these projects, as the former will dampen the ROE more than the latter will, there is room for the latter as the overall debt equity ratio of India is a healthy 0.56, and hence the chances of India Inc raising debt are higher.

Expansions in sales will again put working capital under pressure as firms need to keep enough inventories and will have more receivables outstanding. Hence the overall asset turnover will be lower. After tax profit margins will also be reduced due to higher interest payments on the back of increased interest rates as well as the increase in debt funding predicted above. Increase in depreciation as a result of capex will also add to a reduction in the bottom line. Direct tax charges may come down but the net effect will be to reduce after tax or net profit margins.

This leaves us with the question as to whether operating margins will provide some sort of positive anchoring for future ROEs or not. However, historically, operating margins for India Inc have remained in a narrow band around 17% and have never improved consistently.

Based on the above analysis it appears that ROE for the Indian companies will head lower in the years immediately ahead of us.

However, the biggest wild card would be the interest rates. A substantial reduction in them in another year, and we may be looking at some respite for corporate India’s ROE.

Valuations of the Market

Let us run a simple experiment on valuations. Imagine corporate India converts its current equity to an equivalent number of Rs 100 bonds delivering 23% interest per year, which is the current ROE, for 10 years.

We follow the historic assumption that 68% of the profits are retained to add back to the principal each year and assume that these bonds are bought back at book value at the end of 10 years. Assuming the risk free rate of 7%, these bonds would be worth Rs 317 which translates into a price/book value of 3.17 for the S&P CNX 500, while the S&P CNX 500 had an actual p/b of 3.08 as on 3^rd July 2009.

Now repeat the same exercise based on India’s historical ROE of 18.2 per cent. The price drops to Rs 229, or a P/B at 2.29, against 3.06 currently.

The conclusion is that if Indian companies only manage to register the historical ROE — quite a likely scenario, investors are today over-paying for their stocks by a good margin. A rise in interest rates would only make the equation even less attractive.

- Farzan Ghadially

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