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Market Kaisi Hai Abhi?

Or to put it in simple English - Is The Market Overvalued, Fairly Valued Or Undervalued?

It is nearly impossible to call out the market valuation status as too many variables are involved. But no harm in peddling an opinion, especially if one thinks the said opinion is backed by some scientific explanation. So here I go.

Most popular way of valuing markets or any security: The P/E (Price to Earnings) ratio. It has its pluses and minuses but let us not complicate life further and for the time being go with the belief that P/E ratio is the appropriate way to value the market.

Invert the PE ratio and you get earnings yield (EY henceforth). A P/E ratio of 20 gives EY of 5%.

Nifty 500’s closing P/E on 30th September 2023 was 23.45. That gives markets earnings yield as 4.26%. Though this doesn’t give the faintest idea whether market is undervalued, overvalued or appropriately valued. Until you bring in some benchmark. See, there is no running way from comparing one thing to the other – one has to look how a subject is relative to another. So, in comes earnings yield of whatever instrument one considers risk free. Let’s say I consider 5 years government bond as a risk free instrument.  They currently yield nearly 7.25%, pre tax (source: RBI Retail Direct portal).  Assuming one falls in 30% tax bracket and interest income being fully taxable, after tax risk free EY comes at 4.99%. As against this, EY for Nifty 500 is 4.26%. But this is pre cost and pre tax. After launch of RBI Retail direct portal, investing in government securities is at zero cost, while investing in an index tracker still comes with some cost, though low, and there are taxes to be paid once you pull out the gains. Let’s simplify life once again and mark down EY for Nifty 500 index by 25%. This should hopefully take care of all costs, including taxes. We now get net EY as 3.20%

To summarize, net risk free EY as on date is 4.99% while Nifty 500 net EY stands at 3.20%. How many years does it take Nifty 500 EY to match up to risk free EY? Remember – Nifty 500 EY is supposed to grow, while the risk free yield, once invested is supposed to stay constant. Will it be fair to say that if Nifty 500 EY reaches risk free yield in 5 years, market is fairly valued? I would like to go by this reasoning – unconventional (read as without any back testing support) it maybe. Lot of simplification here but remember, keeping things simple is also our goal. As it is, there is no surety one will do better by making things complex.

Going by this, a nominal annualized growth rate of nearly 9.30% in earnings will let Nifty 500 EY reach risk free earnings yield in 5 years. If we assume 5% of growth will come from inflation, earnings still need to grow by upwards of 4% on real basis. Research shows broader market earnings growth is closely linked to country’s per capita GDP. As per macroeconomic data available publicly through NSO / RBI, while India’s per capita GDP growth for latest two FY’s is well above 6% (real basis), 5 year annualized growth in per capita GDP is around 3% (real basis). Given this context, 4% real earnings growth for Nifty 500 is being optimistic and one can say markets have moved into high risk (read as overvalued) zone!!!

The catch with above opinion, and pretty big ones at that:

-          Per capita GDP growth rate and Nifty 500 earnings growth may surprise us on the positive side

-          Risk free interest rates may go down, by a significant margin

And that’s why it is pretty difficult to be exact about market valuation at any point of time.

 

 

Never forget: standard disclaimers apply. Treat the content on this blog for educational purpose only. Do not base your investment decisions on my opinion in this or any other post in this blog. Exercise due caution and use your judgement. After all, it’s your money which is at stake!!!

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