23 of the 30 Dow Jones companies offer higher dividend yield than that on the 10-year US govt bond, against none for the Sensex
Indian equity investors should brace for more volatility and downside risks in the coming months, with the risk-reward ratio now favouring the US equity market, compared to the Indian one.
The 30-stock Dow Jones index, while offering more rewards than the BSE Sensex, is cheaper than the Indian benchmark.
Besides, exposure to the US market doesn’t carry currency risks for foreign investors, unlike exposure to Indian equity.
Through the past five years, the rupee has fallen at a compounded annual rate of 5.2 per cent.
In FY15, Dow Jones companies reported 19.7 per cent return on equity, against 12.8 per cent reported by Sensex companies.
And, the trend suggests while RoE is steadily improving in the US, it continues to deteriorate on Dalal Street.
This, however, isn’t reflected in the valuations of the two indices: the Indian market remains more expensive than its American counterpart.
At the end of March this year, Sensex companies were valued at 22 times their combined net profit (on a consolidated basis) for FY15.
By comparison, Dow Jones companies were trading at 14.9 times their earnings in calendar year 2014.
Since then, the valuations have moderated due to a fall in markets, but the gap remains.
At the end of trading on Monday, the Sensex was trading at 20.8 times its trailing 12-month earnings, higher than the Dow Jones earnings multiple of 14.3 on Monday.
Also, top American companies now offer higher earnings yield than their Indian counterparts.
At the end of December last year, American companies offered an earnings yield of 6.7 per cent to their investors, assuming they distribute their entire profits as equity dividend.
For Sensex companies, the figure is 4.5 per cent. Of the 30 companies in the Dow Jones, 23 offer higher dividend yield at current prices compared to the prevailing yield on the 10-year US government bond (2.16 per cent), against none for Sensex companies.
The analysis is based on the 11-year financial data and the year-end market capitalisation of the companies that are part of the Dow Jones Industrial Average Index and the BSE Sensex, respectively.
The sample excludes Visa Inc and Coal India, data on whose market capitalisation aren’t available for the entire period considered.
The combination of low RoE and higher earnings multiple makes the Sensex about twice as expensive as the Dow Jones, in terms of the price-to-equity ratio.
At the end of March this year, the Sensex was valued at a price-to-equity ratio of 1.75, more than twice the corresponding ratio of 0.76 for the Dow Jones.
The price-to-equity ratio is calculated by dividing the price-to-earnings multiple by the security underlying return on equity; the lower the ratio, the cheaper the security.
Analysts say this is one of the reasons why equity markets in India and other emerging markets have turned volatile in recent weeks.
“A combination of low potential returns, higher valuation and currency risks has made Indian markets a riskier bet than developed markets such as the US.
"If corporate earnings don’t take off fast, I foresee more downside risks for Indian markets,” says Dhananjay Sinha, head (institutional equity), Emkay Global Financial Services.
“Foreign institutional investors are willing to accept higher valuation and low RoEs, as long as the companies are growing faster.
Unfortunately, earnings growth in India declined sharply in the past two years and worsened the valuation ratios of the Indian market,” says Anoop Bhaskar, head (equity), UTI Asset Management Company.
“Investors are betting on the start of a new growth cycle and if it comes through in the next few quarters, they will forget about higher valuations in India.”
History, however, suggests valuation ratios matter. Before the 2008 global financial crisis, RoEs were higher in India, as was earnings growth, making the Sensex cheaper than the Dow Jones.
This drew foreign investors.
The growth premium India enjoyed has largely been lost.
In the past five years, the cumulative net profit of Sensex companies has fallen 14 per cent, in dollar terms.
In the same period, the combined net profit for Dow Jones companies has risen 26 per cent.
Image: An Indian stock trader reacts. Photograph: Reuters
