In one of my recent posts about why I want Indian elections of 2014 to fail, I mentioned that due to recent run up in stock markets, experts were regularly coming out with one big target after another for Sensex.
Though I hate speculation, the fact is that we are all humans and its unavoidable. I hate it but I speculate every now and then. Very recently, I was fortunate enough to double my investment in MCX in just few months after company’s parent was caught in a crisis. Another stock which I believe can surprise in times to come is SAIL. I did two very detailed posts on why it was a good time to accumulate cyclical stocks like SAIL last year (2013). I still stand by that speculation. 🙂
Anyways, this post is a reaction to a report from a reputed research house, which thinks that Sensex would reach 40,000 soon. (Source)
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| Such Headlines are becoming common these days (Read: rising markets) |
How soon?
If they had said 5 years, it would have meant a reasonable growth rate of 12.5% from current levels of 22,500. And this would have seemed quite achievable considering that chances of India getting a good, business-friendly political environment for next 5 years are pretty high.
But according to the news item, analysts of this research house feel that Sensex would reach 40K in less than 2 years!! (Between 18 and 24 months to be precise)
This means a compounded annual growth rate between 35% and 48% for this period.
Is it possible?
I think it’s a little too optimistic and the research house is being Irrationally (Very) Exuberant. The current P/E multiple for indices like Sensex and Nifty stands at 19. And in case this target of 40,000 was to hold true by end of 2015, it would mean that earnings of constituent companies would have to grow at a rate in excess of 40%, just to keep the P/E of index at 19. And that too for two consecutive years!!
Now here we need to note two things:
- P/E ratio of 19 is not cheap.
- Earnings cannot grow at 40% for two consecutive years (Its not impossible, but its very tough)
Now, P/E Ratio for stocks (and indices) are calculated using below formula:
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| Formula used to calculate P/E Ratios |
So, in case earnings (denominator) don’t grow by 40%; but index (numerator) continues to grow at a rate in excess of 40%, then this would result in expansion (increase) in P/E ratio. This would mean that Sensex would become more expensive than current P/E ratio of 19. And stock market history tells that P/E multiples in excess of 20 to 24 are unsustainable and markets correct after reaching such levels.
But does it mean that Sensex cannot reach 40K in next two years?
No. Anything is possible.
But common sense says that its better not to believe the so called expert opinions which sound to good to be true.
What do you say?