Bullish on India: India's profit-to-GDP ratio shows the economy is right in the middle of the profit cycle

For FY23, the combined net profit of the top 500 companies accounted for 4.1 percent of the GDP, a decrease from the previous financial year's 4.3 percent due to volatile commodity prices

Over the long haul, stock prices are slaves of earnings. This means earnings growth and the inherent profitability of businesses is what drives stock prices. Juxtaposing the fact that both economy and markets move in cycles, what investors need to figure out is where in the economic cycle we are operating to figure out which way stocks could be moving in the future. As it turns out, despite the surge in profits over the past two years, we are still in mid-cycle with respect to profits.

Data over the past two decades shows that the ratio of corporate profit to GDP almost doubled from 2.7 percent to 5.1 percent over the period of 2003–08. During this time, Nifty 500 profits exhibited a growth of 30 percent, which was twice the rate of underlying GDP growth (with a Compound Annual Growth Rate of 14.5 percent) during the same period. However, between 2008 and 2020, as bad loans hit the banking sector and growth became a challenge, corporate earnings were compressed with the Nifty 500 profit-to-GDP ratio dropping from 5.1 percent to 2.3 percent, according to a Motilal Oswal report.

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Some experts highlight that the capacity of corporate India to maintain growth momentum and margins amid global macroeconomic uncertainties will be crucial to pushing forward the profit cycle. The recent surge in crude oil and increase in inflation both globally and domestically is also worrying analysts a wee bit. Even as expectations of recession in major economies have receded, analysts believe the risk has not gone away.

"We must remember that until such time that the global economy and India’s growth path stabilises there will be volatility in this ratio as profits will move inversely with price movements," said Madan Sabnavis, Chief Economist, Bank of Baroda.

Near term concerns may persist, but looking at the medium-term, the fact that we are in the middle of the profit cycle itself means there is inherent potential to better profits from here on as the economy expands. For FY23, the combined net profit of the top 500 companies accounted for 4.1 percent of the GDP, a decrease from the previous financial year's 4.3 percent due to volatile commodity prices. This increase to 4.3 percent had been notable, rising from a mere 3.5 percent in FY21 and 2.3 percent in FY20.

The corporate profit for the Nifty 500 universe grew at a slower pace of 8.7 percent YoY in FY23 after surging 49 percent YoY in FY22 and 50 percent YoY in FY21. In FY23, nominal GDP jumped 16.1 percent faster than FY23 corporate profit growth preceded by 28.4 percent YoY GDP growth in FY22 and a contraction in GDP recorded in 2021.

According to Sruthi Thomas, Assistant VP and Sector Head - Corporate Ratings, ICRA,  while corporate profits have increased in absolute terms over the past couple of years, the improvement in margins have been limited in view of volatile commodity prices, forex movements and inflationary pressures on other cost heads such as energy and logistics. This has also been exacerbated to some extent by the uncertain global macroeconomic environment, she added.

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Meanwhile, Morgan Stanley, in its recent report, is bullish on India and expects India's corporate profit to GDP ratio to touch 8 percent in the next four to five years. This implies a 10 percent nominal GDP, with about 20 percent compounding of headline earnings growth.

This view is supported by a new private capital expenditure cycle and an ongoing government expenditure cycle, after a decade-long lack of spending. Factors driving this include a better growth outlook, global investments shifting towards India, and healthy corporate balance sheets. Corporate debt to GDP has decreased to 50 percent from its peak of 62 percent, and banks have cleaned up their balance sheets. A credit cycle is anticipated, potentially driving private credit to 100 percent of GDP in the next decade.

Government incentives such as lower tax rates and production-linked incentives, along with changing income dynamics, contribute to the growth. Challenges like government deficit consolidation are countered by improved terms of trade and reducing earnings loss to foreign firms when compared to the past, the report added.

Devarsh Vakil, Deputy Head of Retail Research of HDFC Securities has a similar view. Vakil expects profit-to-GDP ratio to reach 6 percent in the next 3-4 years. He expects that in the upcoming fiscal year, FY24, the combined profit pool is projected to expand by 20 percent to reach Rs 14 trillion, resulting in a net profit-to-GDP ratio of 4.7 percent. Commodities are expected to be a significant contributor to the expansion of the profit pool in FY24, with an estimated growth rate of 28 percent. Additionally, discretionary consumption is predicted to experience the fastest growth within the profit pool, with a growth rate of 46 percent.

"Furthermore, India's non-financial corporate debt stands at a mere 51 percent, indicating that companies have substantial room for borrowing to enhance their capacity while using the same balance sheet. This has the potential to lead to profit generation, provided there is demand for their products,” adds Vakil.

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