Valuations are much reasonable based on ‘asset approach’

Equities are usually valued either based on their income or based on their assets. Among the two major valuation approaches ‘asset approach’ uses P/B (price to book) ratio and the ‘income approach’ using P/E (price to earnings) ratio. According to Vinod Karki of ICICI Securities, the Nifty 50 index is currently trading at relatively reasonable valuations on P/B basis at 3.6x, which is 0.77 standard deviation above long term averages, largely driven by cheaper valuations of capital-intensive sectors.

“Peak P/B was hit at 6x in early 2008 when the Nifty 50 RoE (return on equity) hit 29% on the back of high operating and financial leverage as compared to the sub-optimal 12% currently. In fact, 46% of NSE 200 universe in capital intensive sectors is currently trading at P/B z-score of less than zero,” Karki said.
Augmenting the picture further, existing assets are expected to improve their productivity or EVA (Economic value added) in the form of improving RoEs (return on equities) from around 10.5% in FY20 to 15% in FY23 largely led by capital intensive and cyclical stocks, explained Karki.

Whereas on the income approach (P/E basis) the Nifty 50 is at 22.4x (+1.4 standard deviation) and approaching pre-global financial crisis level reached in Nov 2007. According to ICICI Securities backtest over the past two decades in the pre-covid era indicates largely negative one year forward returns from above +1 standard deviation levels.

However, the brokerage firm believes that there are two major distortions. Record high valuations of low volatility, high RoE and growth stocks further flaring up due to the impact of covid on profitability and slowdown in domestic consumption. Relatively weak profitability (RoE) of certain capital intensive and cyclical sectors is inflating their P/Es.

“These distortions have resulted in the market outperforming despite +1 standard deviation on P/E basis sustaining from June’20 for the first time over the past two decades and rendering it to be an ineffective factor for gauging forward returns. While on the ‘asset approach’ the P/B continued to be below the long term average mark right upto Dec’20 starting from Mar’20 and turned out to be a much better valuation metric for predicting future returns,” Karki explained.

From the largecaps space, the brokerage house is bullish on HDFC Bank, SBI, HDFC Life, Bharti Airtel, Tata Motors, Motherson Sumi, Hindalco, NTPC, Ultratech Cement and ONGC. Whereas from the mid & smallcap space Tata Communications, Hindustan Aeronautics, Oil India, CESC, Alkem Laboratories, TVS Motors, INOX and TCI Express are its top picks.