Measuring Valuations: Look Ahead, Not Back

A number of recent research reports have discussed how expensive some stocks are based on trailing-twelve-month price-to-earnings or ‘TTM PE’ ratios. Some fund managers in a closed group call suggested that they are closely watching how expensive certain IT, speciality chemicals, and automotive stocks appear on their TTM PE, and thus warranted a relook. The market itself looks scarily expensive on a TTM PE basis. The table below shows, how, for the widely-tracked and discounted earnings of the Nifty 50, the valuations are a lot more reasonable on an FY22E basis.

Now, the classical importance of the PE ratio is that it helps investors determine the market of a stock as compared to the company’s earnings, which means, the ratio shows what the market is willing to pay today for a stock based on its past or (ideally) future earnings. The TTM PE is the price-to-earnings multiple based on the earnings of the trailing twelve months. Now ask yourselves if the trailing twelve months at a time like this gives a correct indication of the earnings potential or prowess of a sector or a company. 2020 or FY21 is hardly a normalised trending year where you can apply the trailing 12-month PE ratio to determine whether a company is cheap or expensive. It is a time we saw earnings decimation due to lockdowns, business disruption due to supply chains impacted, etc etc etc.

The counter-argument to pundits looking at cheap TTM PE is... why is the TTM PE of a company so cheap? If a company’s earnings in a presumably normalised FY22 are likely to grow significantly, then the market would have discovered and discounted it already, and thus the stock would not remain so cheap on a TTM basis. So rather than searching for a cheap TTM PE stock, which may be cheap because the smart investor is not able to see the earnings growth in it, why not do the reverse of trying to see the earnings growth in sectors and stocks and then checking how expensive the same stock is when mapped against the FY22E and FY23E earnings?

However, the larger point of this piece is not to downplay the valuation methodology that some people follow. For all you know, they may be correct. The point is whether investors who read this math would do themselves a disservice if they believe in the expensiveness of the TTM PE and switch or sell out instead of trying to gauge the earnings potential in FY22 and beyond. Now, don’t get me wrong – I am not saying picture the percentage earnings growth in Q4 of the current year and Q1 of the next year. That will look good. Without doubt. In fact, some companies had near-zero revenues in Q1 of FY21. So Q1FY22 will look fabulous, even if they were operating at 50% capacity utilisation.

The way to put this jigsaw puzzle together may be to sift through the conference call transcripts of the companies in your portfolio, hear what the companies are saying about growth (most of them are saying a lot of things about it), gauging what the earnings are likely to look like at the end of FY22, and then deciding whether the stock that you own is still expensive or reasonably priced.

A BloombergQuint Q3 earnings scorecard story lays out how some of the sectors and themes have performed strongly and handsomely beaten estimates for the quarter. Picture in the kind of performance that these companies will show in Q4 (since March 2020 was not a normal month) and Q1 (which was the lockdown quarter). Then measure the ‘TTM PE’ that these stocks were trading at in December 2020, if that is your sole yardstick. It shouldn’t be.

Here’s what a Credit Suisse note on earnings says for earnings delivered by India Inc. in Q3: “For the BSE100 firms, not only did sales growth climb sharply to +1% YoY in 3Q vs -7% in 2Q (+9% vs +2% ex-oil/metals), only partly helped by a weak base, it was also broad-based, with only 22 firms reporting a decline in sales, the lowest since Jun-2019.”

Now let’s put this in perspective with what has happened thus far. Since the Q2 surprise, earnings estimates have risen. The consensus now expects 14% growth in FY21 Nifty EPS vs +5% in October 2020.

With the assumption that a business-first approach displayed by the government in the last nine months remains, there is a case for business momentum to rebound with each passing quarter. In such a scenario, it would pay, ceteris paribus, to look at companies that have the potential to show strong earnings growth.

Yes... inflation spikes, high valuations, re-emergence of lockdowns could all spoil the party. Turn of flows due to geopolitics or spike in yields or any unforeseen events are all risks. But then, as was the line all retail investors chimed when small caps were running amock in 2020 - risk hain to ishq hain :).

On a serious note, investing is about building a hypothesis and then testing it with reality. Companies are doing the same, when they are talking about the kind of growth that they believe they can show in 2021. Almost all calls speak about volume growth. Yes, a lot of companies simultaneously talk about rising commodity prices which may dampen margins and thus impact earnings. To gauge the fallout of that is difficult, but as Q2FY21 has shown, India Inc. can tighten the belt and put up a good show when pushed into a corner.

If indeed the party poopers don’t play out, then one would well be making a gross misjudgment by looking only at the TTM PE and believing that the portfolios are very expensive. It may help, instead, to also look at potential earnings growth and then determine how expensive the portfolio is 12 months down the line.

Niraj Shah is Markets Editor at BloombergQuint.