After the onslaught of COVID-19 earlier this year when everyone was expecting the stock markets to fall further, it not only rallied but have also touched new highs. The market rally against the backdrop of a gloomy business outlook, however, has raised concerns of extremely valuations of Nifty stocks. Nifty price-to-earning (P/E) ratio has hit an unprecedented 30+.
According to a recent report by ICICI Direct Research, the Nifty PE is at 32.8 (based on FY20 EPS) and trailing-12-month (TTM) PE is at 38.5. Usually, Nifty trading above a PE of 25 is a sign of concern and is considered an expensive market or the market is said to have run ahead of fundamentals. So, what does the current market valuation tell us?
The ICICI Direct report spells out that PE multiple should not be looked in isolation as the TTM PE might be high as first quarter (Q1) of FY20-21 and second quarter (Q2) of FY20-21 were a washout quarter due to Covid-19 and markets are expecting better future earnings.
It also expects PE for the benchmark index to shift to higher orbits as the constituents of Nifty have changed in the past decade and dominated by capital-efficient sectors such as fast-moving consumer goods (FMCG), financials, information technology (IT) and pharma. As these sectors have consistent and predictable earnings, the Nifty PE needs to shift to higher orbits, the report says.
Source: ICICI Direct Research
During the past decade, weightages of sector such as financials, FMCG, IT, Pharma have gone up as is evident from the table above, while weightages of sectors like oil & gas, construction, metals, and telecom have reduced.
According to the report, such changes logically shift the P/E orbit higher as well. Heavyweight sectors have already performed well during first half (H1) of FY21 and recovery in demand will lead to better earnings in FY22-23. Cyclical sectors will also see a cyclical upturn and hence will exhibit better earnings in FY22-23, ICICI Direct says, adding expectation of better earnings is also one of the reasons mentioned in the report as reason for a higher PE.
Another reason for high PE as per the report is that there are nine companies, which have a weightage of 32% in Nifty. Their valuations are based on sum of the parts (SoTP) methodology as these companies have diversification across sectors and each hence each business need to be valued using a different method. So in such a situation looking at a Nifty PE on a standalone basis is not effective since many companies have businesses, which are fast growing than the core business and hence attract higher PE multiple, the report adds.
Using a bottom-up approach of weighted average PE of all individual companies of Nifty based on the expected earnings performance and individual target prices assigned for each stock, it has arrived at a forward PE of 26.2 based on FY23 earnings per share (EPS) of Rs740. To account for any unforeseen risk in the future which might impact earnings it has discounted 10-15% its weighted average PE and after discounting the target PE multiple comes to 22-23.6 times. Based on this multiple the fair value of Nifty as per the ICICI Direct report comes to 16,300.