MOSL: India Strategy (De-constructing market valuations, Lower CoE aids re-rating; Back-testing few RoE frameworks for stock selection)

​India Strategy (De-constructing market valuations, Lower CoE aids re-rating; Back-testing few RoE frameworks for stock selection)

Valuations rich but not euphoric

• Of late, the rich market valuations have been drawing a lot of attention, with the market trading ~23% above the long-period average. Sustenance of healthy macro fundamentals and liquidity has driven valuation re-rating even without concurrent improvement in micros (earnings growth), in our view.
  

Traditional valuation tools don’t explicitly incorporate CoE

• The P/E ratio is a compressed version of comparing the price that investors attach to a firm’s book value (BV) of equity with the profits generated from that equity (return on equity; RoE). However, this metric does not factor in cost of equity (CoE).
  
• For example, a low RoE may suffice if CoE is also low. Yet, a high RoE might not suffice if CoE is higher. This becomes even more crucial in the current environment, wherein CoE for India has come off over the past three years due to lower interest rates. Thus, it becomes important to analyze the market valuations concurrently with the trends in CoE, and not in isolation.
  

Absolute RoE low, but excess RoE over CoE is reasonable

• The trailing P/E ratio at 22.2x is 23% above average. This is because the P/B ratio is marginally higher (10% above average), whereas RoE is 11% below average. However, we note that over March 2014-September 2017, G-sec yields have fallen by more than 200bp, leading to a reduction in CoE, and excess RoE (RoE-CoE) appears reasonable with respect to history. This decline in CoE coupled with resurgent (and consistent) domestic liquidity has led to valuations reigning at premium to long period averages.