Indian stocks cheap for a trillion-dollar economy

Even as the BSE Sensex has risen about eight per cent since September 6, a day before the current rally began, or about 21 per cent year-to-date, all is not lost.

If one considers the market capitalisation to gross domestic product (GDP) ratio, which is frequently used by many large investors to gauge the valuation of a market and understand its possible direction, India's current capitalisation is about 64 per cent of the country's estimated GDP for 2012-13.

This is a little more than its 13-year average of 62 per cent, but about 40 per cent lower than its peak in 2008. This indicates valuations are still low.

During the market rally in 2008, the ratio rose to about 103 per cent. Experts suggest whenever the ratio crosses 100 per cent, once should be cautious.

After Indian markets crashed following the 2008 peak, the ratio dropped to about 55 per cent in 2008-09. Since 2009, though the economy has grown and global uncertainties have partially eased, markets are still trading near long-period averages.

In fact, after the 2008-09 global economic crisis, though India Inc's earnings have improved, valuations remain low.

The combined earnings per share of the 30 Sensex companies has risen from Rs 833 for 2007-08 to Rs 1,125 for 2011-12, a rise of 35 per cent. But the valuations are near the historical average, and this is the reason experts suggest the valuations are comfortable and despite the recent run-up in the markets, investors shouldn't panic.

The valuations are not only comfortable on the basis of market capitalisation to GDP, the price to earnings (PE) ratio, too, paints a similar picture.

According to the PE ratio, an equally important measure widely used to gauge valuations, Indian equity markets are cheaper. Based on FY14 estimated earnings, the price to earnings ratio of the Sensex (at the current levels of 18,713) is about 13 times.

From a historical perspective, this is low. In fact, on this matrix, the market is trading at a discount to the long-term average valuation (10-year average one-year forward price to earnings ratio is 14.8 times; during the 2008 peak, the Sensex price to earnings ratio was 24.6 times the 2008-09 estimated earnings).

One difference is in 2008, markets were hopeful of sustaining strong growth in earnings. However, now, growth expectations have mellowed (10-15 per cent growth in earnings per share), due to slow economic growth.

While the Reserve Bank of India has begun cutting rates and more action is expected on this front, if the government is able to curb the fiscal deficit and raise the country's GDP growth, these should reflect in stronger earnings growth for India Inc.

And, if earnings growth can be sustained at 15-20 per cent, it could lead to a re-rating of the country's stock markets.