How cheap is the Sensex?

The pace of earnings downgrades makes India’s valuation seem deceptive

The doomsayers are making headlines predicting more pain with the Sensex possibly hitting a low of 20,000. While most market pundits blame this on global events, the reality is that India’s muted economic growth is equally worrying. The lower-than-expected GDP numbers (7% as against 7.4%) for the first quarter ignited fresh worries on earnings downgrades, especially as growth expectations for the Sensex pegged at 21% for FY16 of  ₹1,640 per share is fairly high given the economic realities on the ground. During the April to July 2015 period, the index of eight core industries, which includes the energy sector, cement, steel and electricity, reported a mere 2.1% growth compared to 5.5% growth last year in the corresponding period.

The downgrades season started last quarter and is only continuing. "Reflecting a reduction in India's nominal and real GDP growth forecasts for FY16, we are cutting our earnings growth forecasts. Our new numbers are a CAGR of 17.3% and 14% respectively for the BSE Sensex and the broad market versus our previous estimate of 20.8% and 17.5% for the coming two years to FY17," said Ridham Desai of Morgan Stanley in his latest strategy note.

"Consensus earnings estimates are too high, so we will continue to see downgrades for at least the next quarter," says Rajat Rajgarhia, managing director, institutional equities, Motilal Oswal Securities. "We will now see those who take a top-down approach lowering their expectations as a result of lower GDP growth in the past quarter," adds Rajgarhia.

Since June this year, consensus earnings have been slashed by 5.2%. Still, analysts believe that in certain pockets there are still chances of downgrades. Particularly in the case of metals and energy, the falling international prices will adversely impact realisations, and higher inventories will also impact their earnings.

For Sensex, metals are less of a concern with its weightage at a miniscule 1.2%, but the energy and power sectors constitute close to 12%. "It is mostly in the global commodities, where we have seen a huge correction in the commodity prices that the possibility of further downgrades is really high. In the domestic economy as well, both the consumption and investments cycle are not picking up the way it was expected, which is where we think you could see downgrades taking place," explains Rajgarhia.

Another sector that is worrying is banks. "I think one area where the consensus is still behind is banking because if the GDP numbers are lower, and credit growth is not happening, there is a probability of higher provisions and pressure on profitability of the banks while analysts were expecting to see a recovery from this quarter onwards," says  Harendra Kumar, head, institutional equities, Elara Capital. If the stress continues and banks need to write off more NPAs, they could dent earnings further because of their high weightage (29%) in the Sensex.

Already, corporate earnings growth was disappointing in the first quarter of FY16 as Sensex revenues declined by 1% and profits remained flat. Earnings are key to the direction of markets especially in the light of global events where investors are counting on India's relatively better fundamentals compared with other emerging markets. This is also a reason that the Indian markets so far have been able to hold up compared to the huge sell-off in other emerging markets.

India still trades at relatively higher price-earnings (P/E) multiple of 15X FY16 earnings compared to 10-12X in the case of other emerging markets. Lower earnings will make India's valuation even more expensive, which may not be justified. To put it in perspective, if Sensex EPS is downgraded, say, by another ₹100 or about 6%, FY16 P/E will work out to be 17X as against the current one-year forward P/E of 15X. That only makes current market valuation unreliable considering that earnings growth is still in question.