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Stock Market 101

Stock Market 101

When anyone signs up for a class on finance, the first thing they are taught is this: the price of any asset is equal to the cash flow it generates periodically, discounted to factor in the prevailing rate of interest.

When anyone signs up for a class on finance, the first thing they are taught is this: the price of any asset is equal to the cash flow it generates periodically, discounted to factor in the prevailing rate of interest. To put it more simply, when you pay Rs 100 for a stock, it should fetch you at least Rs 106 at the end of first year, given the risk-free rate of return of 6 per cent.

We have not even begun to look things like industry, stock and asset risks, which would further push up your asking rate of the stock. When things are more or less sane, that’s how an asset market works. But when too much money starts chasing too few quality stocks, then this Good Investing 101 flies out of the window.

Tread with caution
 

To an extent, that’s what is happening in the Indian stock markets. A rate cut by the US Federal Reserve has sent billions of dollars gushing towards emerging markets in search of higher returns. For example, some $16 billion dollars (that’s Rs 64,000 crore) has flowed into Dalal Street so far this year, with $4.7 billion coming in September alone. In fact, compared to other Asian markets such as Indonesia, Indian equity has received the most foreign investment in calendar 2007.

Result: the 30 stocks that make up the bellwether index, Sensex, are getting pricey. On a trailing PE (price to earnings), it has topped 25, and on forward PE (which considers March-ending earnings), it is still a relatively high 22.91.

The only stock indices (of the major markets) more expensive than the Sensex are China’s Shenzen and Shanghai, with forward PEs of 51.07 and 45.92, respectively. No doubt, investors are paying a premium for the robust growth in India and China. But how much premium is too much? Unfortunately, at this moment, when there’s too much global liquidity around, that seems like a difficult question to answer.

What’s evident, though, is that one needs to be wary of the soaring stock prices. The Sensex had topped 19,000 when BT went to press, and there was talk of it topping 25,000 well within the end of next calendar year. Are corporate earnings growing as fast? Experts will tell you that the Sensex stocks are expected to grow their bottom lines between 16 and 20 per cent, but there are fresh concerns over the hardening rupee. Just as it makes exports that much less competitive, a dearer rupee makes imports cheaper.

That’ll be a double whammy for companies that sell goods in the domestic and export markets (unless, of course, their products have sizeable imported raw materials in them). There is nothing about corporate earnings that has so dramatically changed (for the better) in a matter of a few months to justify the surge in FII inflows. And that is the worrying bit.