India - Irrational Pessimism;Blue Chips being sold for a song

Prabhakar Sinha & Shankar Raghuraman

NEW DELHI: The stock market is in turmoil and share prices of most companies are tumbling as if there is no tomorrow. In the last nine months,
things seem to have moved from irrational exuberance to irrational pessimism. Nothing illustrates this better than the level of share prices relative to their underlying earnings.

This ratio is what in market jargon is referred to as the price-earnings (P/E) multiple. In essence, the PE ratio of a share tells you how many rupees you have to pay for every rupee worth of net profit of the company.

Thus, if a company has one crore shares and a net profit of Rs 100 crore, each share commands a profit of Rs 100. If you have to pay Rs 200 per share, the PE ratio is 2. In other words, for every two rupees you invest, your effective return is one rupee per year.

Of course, you might actually get in hand only a part of this since only the part of profits that is distributed as dividends is handed over to the investor, but even the rest is reinvested in the company, thus adding to the value of your share. It should be clear that this is a fantastic rate of return, considering that to earn one rupee a year from a bank fixed deposit you would need to invest about Rs 10.

Today, share prices have fallen so much that in many cases, the PE ratio is down to 2 or even lower. That means if you are investing Rs 100 to buy a share of such a company, your investment will earn Rs 50 or even more in one year.

For those who are skeptical about whether the reinvested portion of profits really helps them, here's the opinion of Warren Buffet, one of the world's richest men and widely regarded as among the most savvy investors.

Buffett believes companies that reinvest the entire amount back are a better bet to put your money in. He has argued that you buy a share because it gives you betters return than investment in other instruments.

If a company is growing, it will need to invest in the future and hence distribute little or nothing as dividend. Such a company is actually enhancing your returns for the future.

On the other hand, a company that gives back the entire earning in the form of dividend is effectively telling you it cannot find anything to do with the money, which means it is unlikely to grow and hence likely to yield low returns in future.

On average, good companies with a healthy future tend to earn returns of around 20% on their total investment as against a return on bank deposits of around 10%. In normal times, PE ratios of blue chip companies would of the order of 20, though in cases where future earnings are expected to be much higher you could have correspondingly higher PE. (Of course, it varies from industry to industry, which is why it makes more sense to compare PEs of companies within a certain industry rather than across industries.)

That brings us back to the abnormally low PE ratios for several blue chips in the Indian market today (see chart). Take the example of Hindalco Industries. Its annualized net profit on the basis of its first quarter result for 2008-09 would be Rs 2,787 crore. It has 122.65 crore shares. Therefore, every share of the company has an underlying profit Rs 22.64. But a Hindalco share could be bought on Monday for just Rs 40.40. That means, an investment of Rs 40.40 could earn a net profit of Rs 22.64 in one year, a PE ratio of 1.78. That's an annual rate of return of over 56%.
Similarly, Tata Steel's PE ratio of 2.11 at Monday's closing price means buying the share gives you an annualized return of over 47%. Including
these two, there are at the moment seven scrips out of the 30 in the sensex that are trading at PE multiples of less than 5. In other words, the underlying return on investments in these scrips would be over 20% per annum.

Of course, there is a caveat to be added here. These calculations are all assuming that results declared so far are a good indicator of annualized earnings. If earnings in the remaining quarters do not match up to what was achieved in the first quarter, then PE multiples would be higher even at the same share prices.

Even if the PE multiples rise to say 10, it would make sense to invest provided the company is growing in the long run. After all, when you invest in equity you are looking not only at returns from earnings, but also at potential capital appreciation.