Historically, India has enjoyed higher multiples because of better quality of earnings but with return on equity peaking, analysts say that foreign investors may become reluctant to keep paying the premium they once did.
A slower growth in earnings at a time when most companies have their capital expansions underway poses a threat to the return ratios. “Over the past few quarters, the margins have peaked and it’s but natural that return ratios are being impacted:’ says Rajat Rajgharia, head of research, Motilal Oswal Securities, That is particularly disturbing because high return ratios have been one of the fundamental reasons why Indian equities commanded premium valuations compared to other markets. Lower returns could potentially make India markets less attractive dragging down valuations.
In the past few years, Indian companies have averaged ROE of more than 20 per cent — higher than both emerging and developing markets. In the past one year, for instance, the average PIE for India stocks stood at 22; the average for emerging markets was 15 per cent. In the past 10 years, too, the ROE of Indian companies, have, on average increased from below 15 per cent to more than 20 per cent. In contrast, ROE in emerging markets in the same period climbed from a modest five per cent to about 15 per cent while those in developed markets barely budged from the 10 per cent mark.
What drove this remarkable rise in Indian ROE? Very simply, higher asset turnovers. This, in turn, was driven by strong consumption growth (spurred primarily by government and personal borrowing), and lifted capacity utilizations above 100 per cent in the past four years. In contrast, capacity utilisation rates in other emerging markets and the rest of the world languished at around 70 per cent. Nevertheless, with Indian corporate balance sheets now boasting low debt-equity ratios and strong cash flows, that trend may be set to reverse soon.
Most companies are now running at full capacity or in the midst of capacity expansion. Usually when additional capacities come on stream, asset utilisation rates slide, affecting a company’s ability to maintain its ROE. In the quarter ending March, capital expenditure announcements by India Inc soared by 66 per cent to $174 billion from the $105 billion lined up in the earlier quarter (ending December 2007), according to a study by industry body Assocham. In particular, hectic expansion has been underway in cement, steel, oil and gas, power and infrastructure. A slowing economy — and the resultant slow growth in earnings — means that any additional capital deployed will take longer to produce the same rate of return, depressing the ROE. According to Morgan Stanley, in the worst-case scenario, the ROE of the BSE Sensex companies could decline by 400 basis points from its 2008 levels — a possibility markets haven’t factored in yet. “Though returns on equity are likely to dip in the next one to two years, we expect them to come back in the 20s in the next 3-4 years.
“Typically, the back of high profit growth which fetches higher valuations:’ points out Rajgharia. It explains why India has always commanded premium valuations over emerging markets — and why those days may soon be over. The expected slowdown in earnings combined with rising capex will almost certainly lead to a decline in return ratios and lower valuations. Indeed, India’s fortunes have already started waning: Since the beginning of this year, India’s benchmark index has lost more 25 per cent making it the second worst performing market after China in 2008.
As a result the P/E premium over emerging markets has also plunged to 11 per cent from a steep 64 per cent in December 2007.
Related posts:
