Sensex Valuation and Return Potential

During the past five years, the Sensex has delivered annual average earnings of Rs 630. A market trading at 13,750 has a 21X prior cycle earnings multiple; it certainly looks expensive. Yet one has to consider that the year ended 31 March 2009 is expected to be a trough earnings year; Sensex delivered earnings of Rs 850 during this year.

Going forward, over the coming political cycle, GDP growth in India can be expected to grow at at least 6%. Because GDP growth reflects slower growth rates in the agrarian sector of the economy, this should translate to 9% growth in corporate earnings. With reversion to a 6% long term inflation rate, nominal earnings growth can be expected to hit 15%.

6% GDP growth is a fairly subdued cycle growth estimate; it marks growth expectation down from 8.5% achieved in the prior political cycle. I have used this low level because the high fiscal deficit (expected to be 6.8% of GDP at Center level and an additional 4% at State Level and some more due to invisible deficits caused by the petroleum subsidies) might trigger a credit downgrade if not controlled. In addition, a large borrowing requirement will ultimately push interest rates up; one outcome of higher interest rates could be subdued growth. Finally, India's dependence on exports is low relative to other emerging markets; nonetheless there is a degree of dependence since somewhere between 20% and 25% of GDP comes from exports.

With 15% nominal earnings growth, the forward cycle earnings average is approximately Rs 1,150; the markets are trading at approximately 12X this number. This is not overly expensive.

Consider where the Sensex might trade five years out. With earnings rising to Rs 1,700 (based on 15% annual nominal earnings growth) the market would be:

Cheaply Valued at 10X = 17,000 (absolute return of 23% over 5 years; annualized 4.5%)

Fairly Valued at 15X = 25,500 (absolute return of 85% over 5 years; annualized 13.5%)

Expensive Valuation at 20X = 34,000 (absolute return of 246% over 5 years; annualized 20%)

Bubble Valuation at 30X = 51,000 (absolute return of 370% over 5 years; annualized 30%).

With long term interest rates expected to run at 8.5%, there is an adequate premium because the expected (fair value) return is a full 5% points in excess.

$ investors could stand to gain even more. The Rs is valued at near $1=Rs 50. As risk aversion recedes and capital flows into emerging markets the Rs can be expected to strengthen to near Rs 42. Thus investing $1 today buys you Rs 50. When you exit, your Rs 50 is worth $1.19.

Of course the margin of safety and return potential was higher when the market traded at its lows in November last year and then again with a higher low in March this year. But that time is past.

The market should pull back short term. Personally, I expect it to fill the gap up from the euphoric election result rise (12.1k levels); it could go lower; it could go higher - NOBODY KNOWS. This is why I say buy when you have an expected return giving you a 5% risk premium; and then buy more when risk premiums rise!