Valuation Deep Dive: Are Indian Equities Priced Beyond Perfection?

Indian markets find themselves unmoved from the centre-stage of an age-old debate: are the country's equities priced to perfection or beyond comfort?

A growing number of India-listed stocks are trading closer to their three-year average valuation multiples, moderating from levels that suggested a build-up of froth over the last year.

The most common metric used to ascertain a company's 'fair price' or its 'value' has been the price-to-earnings multiple, or the PE ratio. The measure compares per-share price against earnings per share. In order to estimate whether valuations are running high or not, they can be compared to historic levels or what the peers are trading at.

As Indian equities saw a surge in prices supported by a broad-based bull rally during the financial year ended March 2024, there were concerns over valuations being stretched.

At their peak, the NSE's midcap and smallcap indices were trading at price-to-earnings multiples of 37.7 times and 33 times respectively, significantly above their three-year averages and have since pared to trade below the historic averages.

Without a decline in prices, the only way for valuations to normalise would be earnings growth. However, the nature of markets is such that they price in expectations of profits ahead of actual results, often pricing in earnings which will materialise a year later or even further ahead.

Valuations based on these metrics are known as forward valuations. These metrics do not require an upgrade in actual earnings to update, only in analysts' estimates of earnings over the next 12 months.

Even on a forward-valuation basis, the benchmark and broader market index valuations have traded closer to their three-year average levels.

As a result of positive expectations in earnings, a growing number of companies are now trading near three-year averages, moderating from elevated levels during the past year.

Of the 690 stocks that have analysts' estimates according to Bloomberg data, over 300 of them are currently below their three-year average. On the basis of forward earnings, this number approaches 240.

Currently, the Nifty 50 index trades below both the three-year average of its historic valuations, as well as those based on forward estimates, while the mid and small-cap indices trade near the three-year average levels on both fronts.

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