In the last two years even though the Sensex has surged, the price-to-earnings ratio (PE) – a metric used by analysts to gauge the valuations – has been in a downtrend, clearly outlining that earnings have grown at a rapid pace.
As of November 24, when the Sensex hit a fresh all-time high level, it traded at a trailing twelve-month (TTM) PE of 23.11, which is the lowest in the last 30 instances when the index has made all-time highs.
PE ratio has two components – price and earnings. When the ratio contracts, this usually means either of two things: the price has been falling or earnings have been increasing at a faster pace than the price. Sometimes both happen together, and then it hits the sweet spot, which is what has happened in the last one year.
Since October 2021 when Sensex hit an all-time high last time, the index saw corrections. At the same time, the earnings growth of constituent companies expanded when India opened up after a crippling lockdown period. Both instances happening at the same time led to a contraction of 568 basis points in PE from the last peak to the fresh peak on November 24.
However, things may change now. As the Western world is facing recession, some impact will also be on Indian companies. This may lead to plateauing of earnings growth or even a contraction. This along with any further rise in Sensex levels will eventually lead to the expansion of PE.
Analysts expect corporate profits in India to grow in the mid-teens next year and in 2024. Even as this growth is higher relative to India’s past growth rate and expected growth rate of 8 percent for much of Asia, it means during CY23 -24, the growth will not expand.
“This superior earnings growth outlook appears priced in, as the market trades at 22 times 1-year forward PE, 30 percent above the long-term average and at an elevated PE premium of 80 percent compared to the Asia-Pacific region,” said Sunil Koul, an analyst at Goldman Sachs.
Much of the earnings growth in recent years has come on the back of banks and financials. Banks have consistently beaten expectations in recent few quarters riding on superior credit and deposit growth rates.
Bars in chart represent PE levels when Sensex hit a high.
Financials are likely to continue their terrific show. However, the revenue of India Inc., excluding financials, will come down sharply as it will reflect the normalisation in commodity-related earnings, fading of the reopening boost and slowdown in tech revenues on weak global demand, the market expert pointed out.
This may have a restraining impact on indices in the short term and Sensex and Nifty may be range bound. However, in the long run, most analysts believe Indian markets will soar to new highs, thanks to stronger economic and earnings growth.Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.