In the short run, the market is a voting machine but in the long run, it is a weighing machine— Benjamin Graham
As far the state elections are concerned, the voting is over, results are out and markets have cheered them already. The scorecards of political parties announce the average public opinion about their ability to run the state affairs efficiently. The process of weighting the performance of elected candidates may continue over the next five years and in the end that matters the most, doesn’t it?
The same principle applies to the stock market. The stock prices, expert opinions, everyday news flow and the inflow of new money decide the market direction in the short run. But in the long run, the performance of companies matters the most.
In that sense, Indian markets still appear to be in the voting phase!
On November 26, 2021, CDSL issued a press-release declaring that it crossed the mark of 5 crore accounts. And guess what, by the end of February 2022 the tally of accounts with CDSL zoomed past 6 crore. The tier-2 and tier-3 cities have been contributing to the total of new accounts. We haven’t even considered the scoreboard of NSDL.
Clearly, markets are gaining popularity in India (ahead of LIC IPO). Had domestic investors not propped up markets, the FPI (Foreign Portfolio Investors) outflows of 1.1 lakh crore in 2022 so far might have pulled the rug out from under the Indian equities.
Now let’s come to the ‘weighting’ part.
Price-to-Earnings (P/E) ratio is one of the most widely used valuation ratios that measures the attractiveness of ‘stock price’ (P) with respect to the company’s ‘Earnings’ (E). Earnings can be trail or forecasted earnings.
At present, the P/E of Nifty 500 is hovering above its long period averages. But does that make all the index constituents unattractive?
We decided to find the answer using a small variation of P/E ratio.
The conventional formula for P/E= Price per share/Earnings Per share
The one we used instead was: Market capitalization/ (Net profit + Depreciation)
In other words, we considered cash profits to arrive at the valuation multiples of Nifty 500 constituents on trailing twelve month earnings. Since depreciation is a non-cash item on the profit and loss account of a company it was added back to the net profit. Higher depreciation, at times, can make valuations look stretched.
Not much to our surprise, some large capital intensive businesses having a large base of fixed assets topped the list of companies claiming the highest amount of depreciation. However, a few large IT companies also made it to this list.
Companies witnessing a sharp difference between conventional and adjusted P/E have been from across the sectors and market capitalizations. Capital requirements of their businesses differ too. Some of them are manufacturing companies while others cater to the services sector.
Many of them may suddenly start looking inexpensive or reasonably valued.
Using cash earnings to calculate the earnings multiple may also come handy besides using the conventional P/E ratio. We don’t say this is a full-proof method either.
The common objective of various valuation metrics is to spot companies wherein valuations haven’t run ahead of their earnings potential.
We would like to know what stock selection criteria you follow. Do leave your reply in the comments section. And if you found this variation of P/E helpful, please don’t forget to share it with your friends.
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