Why stocks are now more expensive than in early 2008

Top 1,000 non-financial firms are trading at 25x their trailing earnings, compared to 17.6x in 2008 and 29.5x in 2000

Stocks are now more expensive than on the eve of the 2008 Lehman crisis, while valuations are inching close to the highs of the 2000 dot-com bubble.

India’s top 1,000 non-financial listed firms are trading at 25 times their earnings in the past four trailing quarters, higher than the price-to-earnings multiple of 17.6 in March 2008 and 20 per cent cheaper than 29.5 in March 2000.

The market also looks pricey on two other valuation parameters -- price-to-book value ratio and earnings yield.

Stocks of the sample 1,000 companies were trading at 2.9 times their book value, or the combined net worth (or equity) of all the companies in the sample at the end of March 2014.

The corresponding ratio was 3.6 in March 2008 and 2.8 in March 2008.

For the sample 1,000 companies, the earnings yield has dropped to 4.1 per cent, lower than the corresponding ratio (5.8 per cent) in March 2008 and close to March 2000 (3.4 per cent).

On this basis, the stocks were relatively cheaper in 2008, on the eve of the Lehman Brothers’ collapse.

Earnings yield, the ratio of a company’s latest annual net profit to its market capitalisation, shows the yield to an equity investor if the company distributes its entire net profit as equity dividends.

The analysis is based on the profitability and market capitalisation of India’s top 1,000 non-financial firms, according to their revenues for every financial year from March 1995.

For a particular financial year, the sample includes the firms listed on stock exchanges that year.

The current valuation is based on the net profits of these companies for the trailing 12 months ended December 2014.

If in 2000, there was exuberance in information technology and new media stocks, with Wipro and Zee Entertainment trading at about 500 times their trailing earnings, investors are now giving triple-digit valuations to mid-sized companies in the auto and auto component and consumer goods sectors.

For instance, auto component maker Mahindra CIE is trading at 200 times its trailing earnings, while its peers Wabco India and Bosch are trading at 86.3 times and 77.1 times, respectively.

Gillette India is the most expensive consumer goods maker, with a price-earnings multiple of 197.

The trend is seen even if extreme valuations are excluded and median ones are considered.

A typical company in the sample group is valued at 12 times its trailing earnings compared to 10.7 in March 2008 and 4.8 in March 2000.

In the past 20 years, the stocks have traded at 16.7 times their trailing earnings and 2.2 times their book value, on an average.

Such a high valuation is making many experts cautious.

“The rally is being driven by expectations and strong liquidity flow.

"But expectations have not been realised, as Nifty companies earnings are growing in single digits, with no sign of a quick revival,” says Dhananjay Sinha, head of institutional equity at Emkay Global Financial Services.

He says the domestic business cycle is similar to that in 2001-02 but stock valuations are at the levels last seen in 2007.

“This has created a wide gap between earnings multiples and underlying earnings growth,” he adds.

Others blame it on the valuation re-rating in the mid- and small-cap space.

“There is lot of exuberance in many pockets of the market, especially mid-caps and small-caps.

"This doesn’t mean the market might not rise further, but we are no more comfortable with the valuations given strong earnings growth is yet to materialise,” says the research head at a brokerage house.

“Even if valuations are stretched at the moment, what are the options for a investor right now?

"Through the next five to seven years, there is a greater possibility of investors losing money in bonds, real estate or commodity than equities.

"This makes a strong case for raising the share of equity in your portfolio,” says Anoop Bhaskar, head of equity at UTI Mutual Fund.

Still, for equity investors, the risk-to-reward ratio is worsening with each market high.

At current valuations, it will take investors about 80 years to recover their equity investments at the current earnings yield, assuming an average pay-out ratio of 30 per cent for India Inc.

This figure was close to 45 years in 2003 and 2009, when two major rallies started.

Image: The Bombay Stock Exchange. Photograph: Reuters