A question that bothers participants in India’s stock market is the valuation of stocks. Corporate earnings have grown very little for several years: the average rate of growth of earnings per share (EPS) for BSE Sensex is 5.16% over the period 2008-18.
In fact, in real terms, the average growth rate of earnings is -1.88%. This has happened despite the Indian economy growing at about 7% per annum over the last ten years.
This has been a conundrum for quite a while now. It is important to resolve the puzzle because the valuation of stocks fundamentally depends on the behaviour of corporate earnings. At present, the price-earnings (P/E) ratio is very high at about 23. The historical and internationally accepted norm is much lower – closer to 15 or so (even the cyclically adjusted price-earnings (CAPE) ratio is high in India).
Is such a high P/E ratio justified even though earnings have not increased for such a long time?
The issue is complex. It involves not just economics but also a bit of history. The Indian economy has gone through a series of shocks. One thing followed another and the aggregate and the cumulative effect of shocks over time has been considerable. It is important to look at the story in its entirety otherwise it is hard to understand why the corporate earnings would stay low and for so long. So, it is important to go back in time and consider different aspects one at a time.
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To begin with, it is important to understand that though the growth rate of gross domestic product (GDP) has been good all these years, it had fallen from a still higher level. This matters.
A boom tends to sow the seeds of a recession. Real investment was very high over the boom period 2003-08. This created excess capacity in subsequent years. This slowed down investment later; investment fell from 28% of gross domestic product (GDP) to 15%. This and other factors had a serious effect on the growth of GDP. The growth rate came down from 9%-10% in 2010-11 to about 6.5%-7% in more recent years. This would obviously have a highly magnified effect on corporate earnings, given that the latter are a residual item in the profit-and-loss-account of a firm. This is important, and it needs to be kept in mind in understanding the effect on corporate earnings.
There is an additional reason why the effect on corporate earnings of a fall in GDP was high in the aftermath of the big boom over the period 2003-08. The debt-equity ratios had become high. So, the vulnerability of corporate earnings in the period after the boom rose.
The real estate industry had been booming for a long time – possibly for a few decades. It is only in the last few years that the industry (except possibly for the ‘affordable housing’ segment) has been going through a severe recession. Research shows that the wealth effect of a fall in home prices on consumption is significant. This, in turn, has affected the economy in general and corporate earnings in particular.
The severity of the recession in the real estate industry is not always very clear from the observed prices. Though these prices have fallen in many places, the effective prices are even lower; these are prices at which transactions can be realistically carried out. There are reasons to believe that it is the effective price that matter for the wealth effect, in which case the effect on consumption and investment demand is considerable.
For several years till 2013, the rupee had not significantly and consistently depreciated against the dollar, even though the inflation rate in India was much higher than that in the US. So, the rupee had shown significant real appreciation against the dollar till about 2013. A correction was inevitable at some stage. And then, in 2013, we had taper tantrum in the wake of the Federal Reserve’s decision to begin withdrawal from its massive expansionary policy. In 2013, the rupee depreciated massively and suddenly.
The-then new governor of the RBI, Raghuram Rajan responded to the situation. Rajan felt that the basic cause for the depreciation of the rupee lay in high inflation. So, he chose to bring down the inflation rate in India from about 10% to about 5% in a short span from 2013 to 2015. The growth rate of reserve money came down sharply from 21.50% in 2010-11 and 14.06% in 2011-12 to as low as 5.99% in 2012-13 and 8.80% in 2013-14.
The new policy worked but there was a cost. Consistent with the experience elsewhere, it took its toll — economic growth slowed down. The growth rate of GDP fell from more than 8% in 2010 to about 5% in 2013. Consequently, the real corporate earnings hardly increased around that time.
We can now come to the two more familiar aspects of the story. Demonetisation was announced on November 8, 2016. This, as we know, had a big impact on the Indian economy. Next came the goods and service tax (GST), which too had considerable impact. The story did not end there.
The humongous non-performing assets (NPAs) recognised in public sector banks (and some private sector banks, and now some non-bank finance companies (NBFCs) like the Infrastructure Leasing and Financial Services (IL&FS) Limited) in India in the last few years reduced corporate earnings directly on a large scale. Given the weight of these financial institutions in the corporate sector till some time back, the aggregate corporate earnings were obviously affected.
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Public authorities were concerned about NPAs. Besides other policies, they responded by bringing in Prompt Corrective Action (PCA). This has reduced bank lending, which has, in turn, adversely affected economic activity and aggregate corporate earnings.
As we see, there have been several reasons why the real corporate earnings have not increased over the last ten years or so. Could it all have been different? New research suggests that the answer is yes. But that is another story.
What lies ahead now? There are important studies that show that corporate earnings tend to be mean reverting eventually at some stage.
This suggests that real corporate earnings should rise in the future. Therein lies some justification for a P/E ratio that is at present very high in India.
Gurbachan Singh is Visiting Faculty, Indian Statistical Institute (Delhi Centre) and Ashoka University.