Valuation worries surface amid record highs. Can market sustain lofty valuations?

Sharp gains in the Indian market have boosted key equity indices - Sensex and Nifty - to record high levels, but have also raised worries about lofty valuations.

While Sensex and Nifty have already logged double-digit gains in 2021 so far, it is the mid and small-cap indices that are stealing the show.

This year so far, Sensex and Nifty are up 11 percent and 13 percent, respectively, while the Nifty Midcap 100 and Nifty Smallcap 100 indices are up 30 and 40 percent, respectively.

In last one year, Sensex and Nifty have risen 45 percent and 47 percent, respectively, while Nifty Midcap 100 and Nifty Smallcap 100 have jumped 77 percent and 107 percent, respectively.

Can the market sustain rich valuations?

As per brokerage firm Motilal Oswal Financial Services, Nifty trades at a 12-month forward P/E (price-to-earnings) of 20.2 times - a 7 percent premium to its 10-year average of 18.8 times. 12-month forward P/B (price-to-book) of Nifty is at 3 times, which is a 15 percent premium to its 10-year average of 2.6 times.

Price-to-earnings ratio (P/E) is a valuation parameter that measures a company's current share price relative to its per-share earnings. And price-to-book ratio (P/B) is a company's current market value to its book value.

The market can sustain these rich valuations if the corporate earnings are better-than-expected, resulting in earnings upgrades.

There are also concerns regarding the lofty valuations of mid and small-caps owing to their outperformance.

"The sharp outperformance of mid-caps, bolstered by healthy earnings, improved sentiment, benign liquidity, and low cost of capital, has more than bridged the valuation gap against large-caps. Current valuations, while not prohibitively expensive, are not lucrative from a risk-reward perspective," Motilal Oswal observed.

Meanwhile, G Chokkalingam, Founder and MD of Equinomics Research & Advisory Private is slightly worried about the outperformance of mid and small-caps.

"I am more worried about the big correction in mid and small-cap stocks. There may be some correction in benchmarks also but I don't think the Sensex or the Nifty will fall badly. Overbought stocks in Nifty may fall and undervalued stocks of the index may rise," said Chokkalingam.

While the Nifty is not cheap at current levels, it is not very expensive either, especially given the fact that we are in the early phase of a recovery cycle where multiples tend to be higher, Jyoti Roy - DVP- Equity Strategist, Angel Broking underscored.

"As we are in the early phase of a recovery cycle there is a possibility of earnings upgrades down the line which will make Nifty valuations reasonable," said Roy.

Ashis Biswas, Head of Technical Research at CapitalVia is of the view that we must evaluate the valuation in the context of liquidity.

Biswas expects FDI inflows into India to rise as the economic recovery gains traction, with FY22 GDP growth projected at 8 percent in fiscal 2021-22 (FY22).

"FPIs invested a record Rs 2.74 trillion ($37 billion) in the Indian market in FY21, the highest level since FY13.

In light of this, we believe that long-term investors need not be concerned about the market's present valuation as long as their focus remains on carefully selecting stocks and staying invested for the long run," said Biswas.

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