Running ahead of its fundamentals.
Paying Rs.100 for something worth Rs.10…that’s how many are today looking at the market/stock valuations. Many are advising people to stay away now as they feel that stock market has run ahead of its fundamentals or is grossly overvalued.
And that brings the question to our mind – what is the concept of valuation itself today?
Traditionally, which is based on academics and globally used, the measure is that of the Price Earnings Ratio of PE Ratio. This is the tool used world over to find the value of the stock vis-à-vis the company’s earnings. In short, the PE indicates what an investor/trader is willing to pay for buying a stock, which is based on the company’s past and sometimes on future earnings.
If that’s so, then we need to ask ourselves if the earnings that we are seeing today, do they really represent the state of the company or even that of the sector? 2020 was an exceptional year, maybe and hopefully, once-in-a-century kind of a year. When that base of extenuating circumstances is what FY21 is all about, how can we use that inflated PE ratio and then say that the valuation is just too expensive?
At the moment, what is happening is that the gradual recovery from the pandemic, which we saw in the Q3 earnings, is boosting the denominators of various ‘valuation’ ratios. And in that sense, we should not allow the current valuations to scare us all off.
Yes, it is also equally true that most stocks have become ‘inflationary’ or are ruling at prices which are not affordable for most of us. Under these circumstances, if you need to pick and choose, then more than valuation, we need to concentrate on the growth aspect. We should studiously study the earnings of the company in detail, pay more attention to the transcripts of the conference calls and look for dialogues which mention growth and how the company has chalked out its trajectory ahead.
Today, we need to apply the PE ratio to not the current earnings but to estimated earnings for FY22 and even FY23. Those, hopefully will be normal years, assuming the vaccine rollout picks up pace and the pandemic is halted. Valuation based on FY22 and more so for FY23 will give us an indication of whether or not the stock or the market is overvalued today.
Thus for all of us who think that the market is overvalued, maybe its time to put on our own thinking caps and look for growth, which in turn will determine the valuation.