How fairly valued is the Indian Stock Market

Investors and traders have to constantly juggle with this question. This was once a million-dollar poser when the Indian economy was dominated by a handful of old-world family businesses. As the seeds of entrepreneurship was sown in the 70s and 80s and got a shot in the arm in early 90s due to liberalisation, it became a billion-dollar question. 
 

It did not take long for Indian wealth creators to add more zeros to make it a trillion-dollar question as the country became the fastest growing major economy in the world. 
 

In October 2021, the two benchmark indices—the BSE Sensex and the NSE Nifty—scaled new peaks. Sensex tested Mt 60k and Nifty entered the adult territory for the first time crossing the 18,000 mark. This was despite the Covid-19 pandemic continuing to rile consumer and sentiments. 
 

It took a pinprick in the global tech valuation bubble to bring some sanity as the overall markets corrected 10-15% by mid-2022. Global tech valuation did bounce back eventually, but the Indian markets had a particularly short-lived correction. 
 

While the tech heavy Nasdaq Composite index hit a new high last week, Indian benchmark indices have been on a more secular rise. Indeed, Nifty broke out from the previous peak in several months ahead of the top two US indices- Nasdaq Composite and Dow Jones- that have just managed to break out to new highs much more recently. 
 

This is despite the slide in Indian currency against the greenback. Rupee depreciation tends to fan flight of offshore capital but the market has behaved counterintuitively. One of the key reasons for this is rise of domestic capital. This started around seven years ago as demonetisation of large valued currency led to asset rebalancing with real estate being pushed down as the first choice to park money. 
 

The incentive structure with tax liability and ease of transacting also pushed more people to look at stock markets either directly or indirectly via mutual funds. This has acted as a counterbalance and supported rich valuations despite a war in Europe that has pushed up oil prices. 
So, net-net how fairly valued is the Indian market currently? Has the flush of domestic liquidity taken it back to insane territory? 
 

The P/B ratio

One can use various metrics to assess fair valuation. The more usual practice is to compare share prices with the profits being pumped out by companies in a bunch or as part of a benchmark index. Another method is to gauge the value of assets of those companies. 
 

The price-to-earnings (P/E) multiple, the most commonly used valuation metrics has its limitation as it is based on past performance which can change due to underlying changes in input prices besides consumer and business sentiments. To be sure, one can use forward multiples but different analyst will have different view on that. 
 

One does have an alternative in the firm of the price-to-book value (P/B) ratio, which gauges the market’s valuation relative to the book value of net assets. We can map out the historical numbers of the P/B ratio of the 50-stock Nifty against the various events over the last 20-25 years to see how the market behaves as it breached the average trendline. 
 

Assessing this metrics over time shows that the average P/B ratio for the Nifty has been around 3.6x. This papers over the highs and lows running across the madness of the dotcom boom (1999-2000), the subprime crisis and its fallout with Lehman Brothers implosion (2007-08), the global liquidity-led bull run ahead of the Covid-19 outbreak, and the tech market rave party in 2020-21. 
 

There are some critical points to be noted here. 
 

The most important one is that the criteria for assessing the ratio changed a few months ago. As a result, the ratio cracked by a fifth straight away without any correction in the indices. This means suddenly the valuation started looking more attractive. However, this gave a false comfort as one was comparing apples to oranges. 
 

Yes, a consolidated picture does provide a better picture of the state of affairs as several large Indian companies comprising the Nifty have scaled up via new arms that have taken gigantic proportions over time. Take India’s biggest company Reliance Industries that has spawned giants with multi-billion dollar assets such as those in retail and communications to name a few. 
 

Then again, many businesses have built large overseas presence via offshore subsidiaries through acquisitions in the last decade and more that was not getting reflected and inflating the valuation multiple, giving a false impression of overvaluation. 
 

In 2007, which was the precursor to the major stock market crash, Nifty’s P/B ratio based on standalone net worth of its constituents had breached a clearly unsustainable level of 6! This corrected thereafter only to move towards the level three years ago when the ratio had crossed the ‘4’ mark after a gap of 12 long years. 
 

Last September it had scaled to around 4.5, a level it had tested previously only to see a healthy correction. Notably, the current Nifty P/B ratio at 3.8 has climbed around 12% since September 2023. 
The Indian market has traditionally traded at a higher P/BV ratio compared to other large markets hat rarely breach the ‘2’ mark. But the current trends show the market is overvalued even against its own historical trends despite an adjusted parameter that may make it more palatable. 
 

Second, and what could well turn out to be more prophetic, the previous two up and down cycles were followed by two- to three-year periods (2001-03 and 2011-14) where the Nifty traded at a discount to its long-term average. That is arguably yet to happen and portends a deeper correction is in the horizon with indices waiting for some trigger. 
To be fair, the flush of domestic liquidity as a new force in the capital market ecosystem may prevent this from happening but there is a real risk lurking around. 
 

Endnote

So where does this leave us with the trillion-dollar question? Indian market is now approaching what is a danger zone. While there has been a minor pullback over the last few weeks, with national elections around the corner, the fate of the current government retaining power and continuing with its policies is already factored in the exuberance of the investors. 
 

While the war in Europe failed to shock the global economy and certainly did not have any significant fallout for India, despite the push to the oil price, any escalation of the continuing tension in the Middle East could lead to a bigger impact on input prices, leading to central banks taking a hawkish stance to control inflation and resulting in a slowdown. 
 

But the single biggest factor that could well decide if Indian market can sustain super rich valuation, is the coming national elections. Long-term investors should do better than cashing out completely but should be prepared to see a correction of sorts in the near term, though this may be preceded by another push upwards. 
 

Indian markets appear to be currently overvalued by 8-10%, based on historical trends of both P/E ratio as well as P/BV. But that does not necessarily mean it would correct by that much due to structural changes with domestic money, unless there is a major trigger with a surprise in the election outcome or fresh global outbreak or large scale war. Any correction of 5% or more may not transpire.