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)
|Such Headlines are becoming common these days (Read: rising markets)|
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:
|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?
- Returns during last 5 years (for everyday since 1995)
- Returns during next 5 years (for everyday till 2008)
|Nifty Stocks: One Year Returns (Dec 2011 – Dec 2012)|
- HDFC Bank
- Power Grid
- Bajaj Auto
- Kotak Mahindra Bank
- Axis Bank
- Hero Motocorp
- Asian Paints
- Bank of Baroda
|Click to enlarge|
- Returns during last 13 years, when segregated on basis of Dividend Yields are –
- This clearly indicates that at current Dividend Yield of 1.6, chances of earning around 20% per annum for next 3 years are quite high! (Caution – The statement is made on basis of historical data. Past performance is no guarantee of future performance.)
- A graph between Dividend Yields and 3-Year-Returns (CAGR) also shows that there is a high (positive) correlation between the two. Higher the dividend yield, higher the returns over 3 year periods.
|Dividend Yield & Return Since 1991 [Click to Enlarge]|
- But one must understand that market does not give enough chances at higher levels. Our analysis shows that out of 2500 trading sessions in last 13 years, markets spent less than 5% (127 days) at dividend yields of more than 2.5 (which offers maximum returns over 3 year periods).
|Days Spent on various Dividend Yields|
In our previous post, we saw that Indian markets are presently trading at PEG ratio of 0.97. We arrived at this figure by dividing current P/E of 16.7 by average growth rate (in last 18 years)of 17.1%.
|Click to enlarge|
- Out of 50 Nifty stocks, we have selected 20 stocks. Basis of selection is our preference for companies which can called as stable stocks and which won’t be in any trouble in case the markets decide to close for next 10 years.
- Before we move further, please make sure that you understand what exactly is a PEG Ratio?
- We have chosen EPS growth rates to represent growth rates of a company. One can also use any other growth rates.
- For each company, we have calculated 3 PEG Ratios –
- Using latest EPS Growth Rates (2010-2011)
- Using Average of all EPS growth rates in last 5 years
- Using least positive EPS growth rates in last 5 years
- Afterwards, we calculated another PEG for each company – Average PEG – which is an arithmetic average of previous three PEGs.
- Normally, a PEG greater than 1 indicates an overvalued company, and less than 1 indicates an undervalued company. But we must understand that PEG is just a ratio and it should always be looked in conjunction with other ratios and numbers.
- For instance, a company like Bharti has an average PEG of 0.33, which is quite an attractive number when looked at on a standalone basis. But if we consider that Bharti operates in a highly competitive industry; has loads of debt due to 3G fee payments and African expansion; has decreasing average revenues per user (ARPU) and has a negative PEG(!) for current fiscal, the number 0.33 may not look so attractive.
- But there are also few companies like BHEL (0.59), PowerGrid (0.83), Tata Steel (0.40) and Tata Motors (0.42) which have considerable moat (competitive advantage & operations in industries having high entry barriers) and can be said to be available at good valuations. But once again, one should understand that stock like Tata Motors are rate sensitive and cyclical. And under current global circumstances, may slip further.
- A company like Sterlite Industries (pegged by few as future RIL) is available at a ridiculous PEG of 0.19 (or 0.25, 0.08, 0.26). But that does not mean that it is going to become a future multibagger. Similarly, Maruti is available at PEG of 0.10(!)
- Then there behemoths like SBI which may be available at outrageous mathematically calculated PEG of 6.6, but are worth investing as there current PEG stands at 0.54. But one should also consider rise in NPAs of SBI and other factors before investing.