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MOSL: INDIA STRATEGY-Hardening bond yield offsets the valuation cushion-Earnings recovery important to sustain valuations

India Strategy: Hardening bond yield offsets the valuation cushion; Earnings recovery important to sustain valuations

Market is no longer cheap on P/B vs. excess RoE framework

In our note De-constructing market valuations, we had argued that even though the market was slightly expensive on P/B vs. RoE framework, it was reasonably valued if one looked at P/B vs. excess RoE framework. Excess RoE is RoE-CoE and is more meaningful as PE doesn't factor in cost of equity (CoE). Essentially, lower cost of capital explained the valuation uplift. However, with bond yields hardening, the advantage of lower CoE has dissipated and the market is no longer inexpensive even on P/B vs. excess RoE framework.

 Hardening of bond yield offsets the valuation cushion

The market's trailing P/E ratio at 22.2x is 22% above average. This is because the P/B ratio is marginally higher (12% above average), whereas RoE is 10% below average. However, we note that over March 2014-September 2017, G-sec yields fell 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 had led to valuations reigning at premium to long period averages. However, with the recent hardening of G-sec yields, cushion from lower cost of capital is receding and sustenance of market multiples hinges on earnings growth, in our view.