valuations: How looking at averages to judge stock valuations can mislead you

A lot of times, the sustainability of market valuations is determined by averages over a certain period of time. If the current valuations are over that of a long-period average, then it is supposed to be an indication of expensiveness of the market and vice versa. However, I believe adjustments need to be made to any such study based on averages.

Overtime, variables that determine valuations may all have changed. Let us look at some of them:

1. The composition of the index itself. The index does not remain constant over time. It undergoes changes. Depending on stock performance, sectoral weightages change. The indices typically work with a fixed number of stocks. Hence, as new stocks gain importance (market-cap and liquidity) with time, some of the old names have to go out.

If we look at the changes in the index between FY08 and FY21, we find that high P/E sectors like private banks, consumer staples, high-growth NBFCs, retail and life insurers have increased their presence. Lower P/E sectors like oil and gas, metals, energy and PSU banks have seen a reduction. Overall, we note a 29 per cent increase in weightages of high P/E sectors and a 33 per cent drop in the weightages of low P/E sectors on the index with some improvement in weightages of sectors with average P/Es.

2. Average Valuations hide more than they reveal. In an index of say 50 stocks, while some names may be having business as usual times, others may be having a better-than-average outlook, which may justify a higher current valuation. At the same time, some sectors may be seeing a sharp impairment in profit outlook temporarily, and hence, they may be enjoying higher P/E valuations for the current period.

For the current period, heavyweight sectors such as IT services have seen a material improvement in their outlook and are now trading above than long-period average. At the same time, profits of some sectors like media and retail have declined sharply due to Covid and their P/E valuations look higher than normal. Both of these factors do not imply that the stock prices are unsustainable (given that they reflect long-period cash flows discounted to present and one period of impairment does not make significant difference to valuations). But they do make the blended valuations of the index look higher.

3. The valuation of a stock and, hence, the average valuation of the index is influenced by the discount rate (usually accepted is risk-free rate of 10-year G-Sec + risk premium). Over time, interest rates may change. This would impact valuations of each stock and the averages.

Over the past one year, we have seen a sharp drop in interest rates. It is no longer confined to treasuries, but has percolated down to rates at which business happens. A decline in interest rates by one per cent could result in a substantial improvement in P/E valuations. Sustainable P/E valuations of businesses could go up sharply by 15-20 per cent for one per cent decline in interest rates. If lower interest rate levels are expected to sustain for the long term (with of course some changes on both sides of current levels), then chances are that valuations would also sustain.

Investors should factor in the above while looking at averages and thinking about sustainability of current valuations. Mechanical corrections may not be possible and it is best to look at each space separately. Averages are at the end averages. In the current market, an analysis of the above factors does indicate that the market levels are sustainable and may, in fact, improve.