For starters, it is important to note that stock markets ignore the past and follow future prospects. Thus, analysts and fund managers focus on forward earnings (profit) rather than trailing earnings.
The Nifty index is a composition of 50 stocks. A stock is worth the present value of the stream of cash flow that it will produce in the future. The present value is calculated by projecting out future free cash flows and discounting them back to the present. Thus, the interest rate that is used for discounting is the key matrix for the valuation of the index and stocks.
The most important point to remember is that interest rates (discount rates) and the present value of cash flow are inversely related. So, lower interest rates means higher present value. In India, the 10-year government securities (G-sec) rate is used as the discounting rate while valuing a company.
Low interest rates are usually good for companies just like they are good for ordinary folk, who buy houses and gadgets on loan. Low interest rates enhance companies’ earnings and earnings per share (EPS). Thus, during a low interest rate regime, the forward earnings multiples are at a higher premium to their five- or 10-year average.
As per Bloomberg Consensus estimate, in FY23 (from April 2022 to March 2023), the Nifty EPS would be Rs 873. Based on the closing price on October 5, the Nifty ended at 17,822 points, which means it is trading at 20.41 times one-year forward earnings (17822/873).
Speaking with Outlook Money, Jaspreet Singh Arora, Chief Investment Officer, Equentis Wealth Advisory Services Pvt Ltd, said before covid hit India in March 2020, the 10-year average of Nifty earnings multiples was 19. Today the P-E multiple of Nifty is 20.
“Do you think we are in a bubble zone or stretched valuation when P-E multiples move from 19 to 20, which is just 5.2 percent above the decade average?” he asked.
Arora has a valid point when we stop seeing the P-E multiples in isolation and count the factors that are driving it higher than its historical average. One of the factors is interest rate. Currently, the 10-year Indian G-secs are yielding 6.25 percent, which is 20 percent lower than its 10-year average of 7.5 percent.
Keeping in mind the 10-year averages, while there is just a 5 per cent premium on the Nifty's forward earnings multiple, the interest rate used for discounting to get the present value of a stock is 20 percent lower. If all else remains equal, then the Nifty is still at a reasonable level and may move much higher from the present levels.
Sushil Kedia, founder and chief executive officer, Kedianomics, believes that the stock market has produced an enormous profit for investors and there is immense liquidity that is supporting the upward rally.
“Markets the world over are inebriated on internal liquidity generated by market profits and sector rotation is technically keeping markets saved from the bunching up of volatility,” he said. Till the time sector the rotation remains, there is no point trying and calling any top for Nifty, he added.