Preparing for the fall

The Nifty is at some 27 times trailing earnings (don't trust forward earnings estimates, which seem to be forecasted linearly). We already have a sense that the projected earnings growth of 20 per cent is not going to meet expectations for even the first year, let alone the three years of compounded 20 per cent growth that is built into expectations just now. Here's how the arithmetic goes. At 27 times trailing earnings, Rs 100 of current earnings (last four quarters) is available at Rs 2,700. Now the long term valuation of a steady market is that it should be valued at the nominal rate of growth (of the economy). This is on the steady state (equilibrium) assumption that corporate profits as a percentage of GDP will stay the same. This ignores the cyclicality of corporate profits (as a percentage of GDP), which follow the waxing and waning of capacity utilisation, the stage of the capex cycle (i.e., leveraging or deleveraging), etc. Without going into the details of the various scenarios, let's say that the nominal growth of the Indian economy is 7 per cent (real growth). Add to it 5 per cent inflation and you get 12 per cent nominal growth. With some small increases coming from the tightening capacity utilisation, you can assume that the existing 3 per cent of GDP that corporates earn will go up somewhat. Hence, you can expect earnings growth of 15 per cent over the foreseeable future. Frankly, that is what the markets seem to have said on an average for a very long time. So, for these markets to be

This article was originally published on March 10, 2018.