The current market meltdown has left the investors shocked and stunned. The only question in everyone’s mind today is does the market have further downside left or has it bottomed out? Practically, everyone is offering some or the other opinion on this question.
We believe that the one of the fundamental ways of reviewing the current market conditions is to look at valuations in the light of their historical values. If, historically, a particular scrip was being valued at 10 times its annual earnings, then we can assume that it reflects its fair value. If the current valuations are substantially above these levels, it will mean that a further downside is to be expected.
The latest rally that the equity market witnessed throughout 2007 peaking in the first week of 2008 stretched the valuations to historic highs. The bullish enthusiasm meant that the future growth potential of companies was discounted at higher rates than witnessed in the past.
In terms of the market lingo, it meant that the price-to-earnings multiples (P/Es) increased to very high level. At its peak in the first week of January 2008, the Sensex P/E had breached the 28 level and it matched the levels last seen during the height of the dotcom boom in 2000.
Reminding of the crash of 2000 could be painful for many investors. It was not only severe, but also long-lived and the bear grip on the markets remained tight for years. The BSE Sensex hit the bottom at 2,924 points in April 2003, when its P/E declined to 12.7.
Only after this, the markets stabilised and then gained gradually. Since September 2007, in just three months, the Sensex gained around 33% — a gain that has been wiped out now. With the crash, the valuations too have moderated with the market capitalisation of Sensex at just 19.4 times its constituents’ trailing 12-month earnings.
A study of the share price movement of the Sensex companies indicates that more than half of them are now trading below their 5-year average PE. Just 11 companies command a PE, which is higher compared with their average PE over past five years period.
Does this mean that fundamentally speaking, the valuations have become reasonable and there is little, if any, downside left? It may not be so. A closer look reveals that the 11 scrips with higher PEs include RIL, ONGC, L&T , HDFC and ICICI. These companies together have 60% weightage in the Sensex, if their valuations were to come down to historical levels, the market will fall substantially.
Comparing the current crash with year 2000 puts forward a key question: will the aftereffects of the current crash continue over the next couple of years as witnessed in 2000? The answer would probably be ‘No’ , as the situations differ considerably.
Looking at the situation from a different angle, market experts are expecting earnings per share of Sensex companies to reach around Rs 950-1 ,000 levels in FY09. Thus, the current Sensex level justifies itself even at a low P/E of 15-16 .
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