The language of equity valuation is spoken in every serious investing conversation in India, yet it remains poorly understood by a large proportion of retail market participants. When financial commentators discuss whether the INDEXBOM: SENSEX is trading at stretched valuations or whether the Nifty 50 is attractively priced relative to historical averages, they are invoking a framework of metrics that experienced investors use to calibrate their expectations and adjust their portfolio positioning. Learning to read and interpret these metrics is among the most valuable skills an investor can develop.
Price-to-Earnings: The Most Widely Used and Misused Metric
The price-to-earnings ratio relates a stock or index price to the earnings per unit of time, usually the last twelve months. At the aggregate index level, this reflects the valuation of all constituent companies weighted by their contribution to the index. If the index PE multiples to a large extent its long-term historical average, this reflects bullishness about future earnings growth (or alternatively, an acceptance of lower future returns). When the index PE is below its long-term average, equities are attractively valued.
The limitation of the trailing PE ratio is that it reflects the earnings of the past, which may not be indicative of future earnings, especially in rapidly evolving economic environments. Forward PE ratios, which use analyst estimates of the next twelve months earnings, provide a more forward-looking view but carry the baggage of the assumed accuracy of earnings forecasts. In the wake of a downcycle, during the period of rapid earnings recovery, trailing PEs might appear inflated while forward PEs appear reasonable.
Price-to-Book and Return on Equity as Paired Indicators
The price-to-book ratio reflects the market price of a stock or index to the book value of the business (on the balance sheet). A high price-to-book ratio reflects a willingness of investors to pay a premium to the book value of the assets that the business owns, which is indicative of a high return on these assets. The return on equity (the profit that a business earns as a proportion of owner’s equity) is therefore the natural paired indicator to the price-to-book ratio.
A business that consistently earns a 20 percent return on equity deserves to trade at a premium over book value (depending on the cost of equity capital to the equity capital). A business that consistently earns only an 8 percent return on equity might in fact deserve to trade below book value depending on the cost of equity capital to the equity capital. Investors who utilise the price-book ratio in isolation without considering the return on equity, run the risk of misidentifying seemingly cheap stocks as cheap because of their inherent low returns.
At the aggregate level, the evolution of the aggregate return on equity over time provides insight into whether the profitability of corporate India is improving or deteriorating. A rising return-on-equity along with a rising price-to-book ratio reflects a market that is getting more expensive in line with improving fundamentals. A rising price-to-book with a stagnant or declining return on equity is a more worrying combination that deserves some caution.
EV / EBITDA and Its Relevance for Capital-Intensive Sectors
Enterprise value to EBITDA (earnings before interest, taxes, depreciation, and amortisation) is a valuation metric that reflects the enterprise value (total market capitalisation of the equity plus debt, minus cash) to operating profits of a business. It is particularly useful for companies that have varying levels of debt and capital structure as it reflects the total cost of acquiring a business (the enterprise value) compared to its core operating profits (EBITDA). This is a more apples-to-apples comparison than simply the price-to-earnings ratio, as it reflects both the equity financing and the debt financing that is used to finance the business.
For sectors such as telecom, infrastructure, and utilities where companies have large amounts of debt and are capital intensive, the price-to-earnings ratio can be misleading as depreciation and interest costs can have a large impact on earnings. The EV/EBITDA metric, which strips out these items, provides a more realistic view of the operating performance and a more comparable valuation.
Understanding Index Valuations in the Context of the Interest Rate Cycle
Equity valuations cannot be viewed in isolation from the prevailing interest rate environment. With risk-free rates (typically reflected by government bond yields) being one of the inputs to determining future cash flows for equities, changes in the risk-free rate will have a direct impact on the present value of future cash flows. This means that rising risk-free rates will mechanically reduce the present value of future cash flows for equities, thereby exerting a downward pressure on equity valuations.
This dynamic reflects why equity markets are often sensitive to moves in interest rates and why periods of rapid interest rate hikes are often accompanied by sell-offs in equities even in the face of improving corporate earnings. The yield gap (difference between earnings yield of the equity index and yield on government securities) is a useful metric in this regard as it reflects the relative value of equities versus bonds at any point in time.
Investors who consider the interest rate context when viewing equity valuations are better able to understand why equity markets react the way they do to changes in RBI policy and able to position their portfolios accordingly during the different phases of an interest rate hike cycle. While valuations that appear rich in a low-interest rate environment might be justified, valuations in a rising interest rate environment deserve more caution and lower equity exposure.
The Short Version
- A large proportion of retail market participants in India poorly understand equity valuation despite its importance in investing conversations.
- The price-to-earnings ratio (PE) is a crucial metric that relates stock or index price to earnings but has limitations due to its reliance on past performance.
- The price-to-book ratio, when considered alongside return on equity, provides greater insight into whether stocks are truly undervalued or overvalued.
- Enterprise value to EBITDA (EV/EBITDA) is especially relevant for capital-intensive sectors, as it better reflects operating performance than the price-to-earnings ratio.
- Equity valuations must be understood within the context of interest rates, as rising risk-free rates can negatively impact equity valuations and present value of future cash flows.
- Monitoring the yield gap between equity index earnings yield and government securities yield helps investors assess the relative value of equities versus bonds.