Sensex Valuations Seem High On A Trailing 12-month Earnings Basis

Earnings and valuations are two most important drivers of stock prices in the long term.

Market Outlook

Sustainability of earnings growth, free cash generation (quality) and valuation (driven by liquidity) provides the direction to the incremental stock market returns. As Peter Lynch once put it “Behind every stock is a company. Find out what it’s doing”. Most active managers focus on earnings growth and free cash generation. Since FY08 earnings growth data has been very skewed with only selective sector/stocks being able to grow at a steady pace i.e. consumer staples, consumer discretionary and IT. Naturally, this segment of the market has performed disproportionately better and valuations for such businesses have moved higher and in some cases to all time high levels. Sensex earnings growth since FY08 on an aggregate basis has been quite muted at 6.5% CAGR resulting in sub optimal return for the index at 9.5% CAGR. ROE profile of the index also deteriorated over the years from a high of Sensex has been corporate banks where past few years have been the weakest in terms of earnings delivery for them.

Earnings growth for Sensex is likely to see a sharp improvement over the next few years led by corporate banks where provisioning coverage has materially improved and we are seeing higher credit growth leading to better NIM especially in light of NBFC sector keeping away in terms of fresh disbursements. Interestingly, along with better earnings growth, ROE profile for the Sensex is also likely to improve towards 15% by FY21 (source – Axis Capital).