Gazing into 2012 – Overvaluation or Undervaluation?

Now that everyone and his uncle are onto the predicting bandwagon in the New Year, I resolved to myself that I shall not let go this golden opportunity to pontificate and predict what might happen in 2012.

Then I said, scratch that. Let’s just see whether the broader market as a whole is undervalued or overvalued right now.

Before that, a review of basics. Over the long term, the broader market (Sensex/Nifty) will grow only at the rate of corporate profits. Corporate profits in turn grow at the rate of nominal GDP (real GDP+Inflation rate). I venture a guess (with a higher probability of being right) that Sensex/Nifty’s growth over the past 10-15 years has been commensurate with the growth in profits of their corporate constituents. Again, that is in the ‘long term’, not year-on-year. But we all want the answer to the question of ‘what about next year – where will the Sensex/Nifty go?’.

Now with this post in mind, and the current Nifty values (P/E: 16.79, P/B: 2.77, Div Yield 1.63), we can deduce that Nifty is in the Low Valuations category. Of course, no one knows how long it will take to move into the high valuations category (or get down to the Very Low valuations category), but in general, it is good sense to start dipping our toes in the broader market by buying the Nifty in parts.

All the above of course was a rehash of what we have spoken on this blog earlier. No new information in there.

In this post, I want to explore a hypothesis on the Sensex (Nifty comprises a broader market as a whole, yes. You can do this analysis for Nifty too).

Refer this post. The summary of that post was, if the Return on a stock (as defined by RoE/RoCE) was equal to the return on a post tax AAA bond yield, then that stock is said to be fairly valued at P/B=1.

For illustrative purposes, if a stock’s RoE = 20%, AAA bond yield is 10%, then the fair P/B would be RoE/AAA bond yield = 20/10 = 2. If the P/B of the stock is 4, then it is said to be over-valued and if it is 0.5, then it is said to be under-valued. (In my discussion with other investors, this seems to be broadly right except when there is pricing power, brand and scale involved).

So, what are the values for Sensex over the past 10 years? (I have taken the 10yr Govt. yield as a proxy for AAA bond yield)

Year RoE (%) Govt. yield(%) P/B Sensex
2000 16.90 11.00 3.50 5205
2001 16.10 11.70 3.00 4018
2002 17.20 8.00 2.30 3269
2003 18.00 6.00 2.20 3365
2004 21.50 5.00 3.30 6026
2005 24.30 6.50 3.70 6679
2006 23.50 7.00 4.40 9390
2007 25.40 7.50 5.20 13942
2008 23.30 7.74 6.50 20465
2009 18.80 5.35 2.50 9958
2010 16.30 7.58 4.10 17558
2011 17.60 8.00 3.70 20561
2012 (E) 18.20 8.40 3.14 15500

In the spirit of the illustration above, let’s divide RoE by the Govt. yield, and compare it to P/B.

Year RoE/Govt yield P/B Sensex
2000 1.54 3.50 5205
2001 1.38 3.00 4018
2002 2.15 2.30 3269
2003 3.00 2.20 3365
2004 4.30 3.30 6026
2005 3.74 3.70 6679
2006 3.36 4.40 9390
2007 3.39 5.20 13942
2008 3.01 6.50 20465
2009 3.51 2.50 9958
2010 2.15 4.10 17558
2011 2.20 3.70 20561
2012 (E) 2.17 3.14 15500

Over the past 10 years, data emerges which confirms our hypothesis. Whenever RoE/Govt yield was greater than the P/B, the Sensex rallied and whenever RoE/Govt. yield was lesser than P/B, the market tanked (as indicated in the initial years of this dataset) (except for the freak year of 2007-08, which as we all now know in hindsight was the peak of the bull market). Let’s plot a graph then (and due to my poor charting skills, I will have to divide RoE/Govt yield by P/B to arrive at a single figure, say x. If x is greater than 1, then the market is undervalued. If x is lesser than 1, the market is overvalued).


As per our hypothesis then, the Sensex at these levels is still overvalued. So, at what point does Sensex become undervalued? Assuming the Govt. yield remains around the 8.4-8.7 levels (and of course, I am trusting our corporates to be like a hawk on their profits and hence protect the RoE at these levels), the undervaluation in Sensex comes around the 10700-11500 range, which is around a 30% drop from these levels. Even if we give a little premium for the ‘India’ story (I don’t know if this is justified though), the Sensex becomes undervalued at 13000-13500.

And just so that we have some other data point to ensure our hypothesis is not way off, let’s see the 15 year averages for Sensex. The 15 year avg. P/E is 14.7, P/B is 2.6 and RoE is 18.8%. The current Sensex values are P/E 16.5, P/B 3.14 and RoE is 18.2%. This indicates that inspite of a similar RoE to the 15 year average, we are very much above the averages in P/E and P/B indicating overvaluation. Unless of course we ramp up the RoE dramatically in the current year and the next (which I see as a low probability scenario in the current conditions), the conclusion is the market is still overvalued.

Views/thoughts/counterpoints invited.


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  1. #1 by Vijay on January 3, 2012 - 9:40 PM

    No. actually the interest rates may fall by 20-30%. i.e. from 8.4 to 6.4 in 1 year. this will change the ratio.

  2. #2 by Rohan Pinto on January 3, 2012 - 11:32 PM

    Hey Kiran, I loved your concept of comparing Nifty ROE with AAA yield as a tool to assess rough value of P/B. Enjoy reading your articles. Keep them coming. Happy Investing! 🙂

  3. #3 by kdaaku on January 3, 2012 - 11:42 PM

    @Vijay – This is not the interest rate. This is the Govt. yield which is far more stickier and is dependent on a whole lot of things, including the Govt’s ability to drive reforms, repay debt etc. Take a range of Govt yield from 7%-9% and try to see which would be a fair value for Sensex. You’ll realise that current levels are still overvalued.

    @Rohan – Thanks. Happy Investing!

  4. #4 by JK on January 5, 2012 - 2:47 AM

    Plz share the source for ROE & Govt Yield numbers…

  5. #5 by Stable Investor on January 6, 2012 - 5:54 AM

    Interesting and innovative approach to calculate undervaluation.

  6. #6 by Vijay on January 8, 2012 - 7:23 PM

    Why can’t the govt yield fall by 20%. 2008- 7.74 2009-5.35. A huge fall.
    Why can’t it fall the same in next 6 months?

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