There’s a thin line that separates a bull market from a bubble. It’s simple—a rise that is supported by an improvement in business profitability is great news. Anything else could be worrisome.
Let’s break the numbers down for easy reading:
How do you know a stock is cheap or costly? You look at the Price-to-Earnings (PE) ratio. It tells you how many rupees you spend compared to a rupee earned by the company. The more you spend, the costlier is the stock. Analysts usually calculate the PE ratio using the expected profit. Currently, the Nifty 50 has a PE ratio of 20x using the expected profit for FY18, according to a report by Kotak Institutional Equities. This is much higher than the average PE ratio of 14-18x. When PE ratios climb above the average, a fall can be expected. Even for the broader market, Kotak analysts found stocks of ‘growth’ companies to be expensive.
It’s equally important to look at Return on Equity (RoE). It helps understand how much profit a company is generating using shareholders’ money. The higher the RoE, the more lucrative is the company’s stock. Over the last few years, prices have risen much faster than the increase in RoE. The Nifty’s RoE stands at 14.1% for FY17. However, for FY18, it’s expected to fall marginally to 13.9%. This shows that investors expect profitability to improve much more than the numbers suggest.
The 50 companies that form the company together reported a profit growth of 23% in the fourth quarter ended March 2017. This exceeded the estimates of Kotak Institutional Equities analysts by 9%. This seems like good news. However, there’s more to the story. The fineprint reveals that only a handful of companies actually exceed estimates. The strong performance of Tata Motors, Tata Steel, Bharat Petroleum, Indian Oil and ONCG helped the Nifty profit growth exceed expectations, the Kotak report said.
The Nifty 50 companies reported a profit growth of 20% during the financial year 2016-17 that ended March 2017. However, it may be better not to take the numbers at face value. The yearly growth too was led by a handful of companies like Indian Oil. This skewed the average growth. And even this growth was not necessarily because of better performance. The profit growth of some companies like SBI and Bank of Baroda was higher simply because of a low base effect. This is when the percentage growth turns higher because of poor performance in the previous year. Such outperformance cannot be trusted as they aren’t consistent.
“Don’t be fooled by the Sensex’s new highs,” reads the headline of a Livemint report. And correctly so, too! The Sensex and Nifty are considered benchmark indices—meant to reflect the performance of the overall market. However, since May 16, 2017, the benchmarks’ have barely reflected the market trend. The Sensex and Nifty have been hitting new highs, but all other stocks with a market capitalisation of less than Rs 1 trillion have been falling.
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