From THE HINDU group of publications
Sunday, June 03, 2001


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Promoters must talk the market up

D. Sampathkumar

EVEN without following the day-to-day gyrations of the BSE Sensex it is safe to say that the market has seen better days. Does the current value reflect better the intrinsic worth of corporate paper? A quick analysis would show that the problem of equity values being down in the cellar lies not with the market but with corporate earnings themselves.

The price earnings ratio of Sensex stocks is currently in the region of 18-20. The investor community would expect that investments in corporate paper should fetch them a minimum of around 18 per cent. This comprises a risk-free rate of return of 10 per cent (one-year T-Bill fetches this). For equity investments, a risk premium of 8 per cent is generally considered reasonable. But corporate earnings have been growing at a nominal rate of 13 per cent. This is made up of a real growth of around 8 per cent in industrial output _ the principal source of corporate incomes _ and an average inflation of around 5 per cent in recent times.

Factoring in the rate of growth in corporate incomes, the effective rate of return investors would demand now comes down to 5 per cent. In other words, for a rupee of corporate return, investors would be willing to pay as much as Rs 20 in exchange. That gives a price-earnings ratio of 20, the level at which Sensex stocks are roughly ruling. If equity values have to go up, corporations have to improve their bottomlines.

Central to the whole question is the debate about market valuation in general, and new economy stocks, in particular. It has been argued that equity valuations at the end of first quarter 2000 were an outcome of some `irrational exuberance' among market participants and that the current values better reflect the underlying fundamentals. But not everyone is convinced. Certainly not SEBI, which seems to think a cabal of short-sellers is behind the artificial suppression of equity values that spoilt, as it were, Mr Sinha's post-Budget party.

Since Indian markets do respond to developments in the US, it would be instructive to look at the debate in that country. Robert Shiller of Yale University, in his book Irrational Exuberance, argued that US investors had indeed taken leave of their senses in bidding prices up to unreasonable levels in the bull phase that began in early 1990s. But his colleague in academia, Robert Hall of Stanford University thought that there was nothing irrational about the market behaviour if one went by the evidence of past valuations and changes in cash-flows measured post facto.

Shiller, of course, primarily based his arguments on the huge swings in market capitalisation, which were out of tune with a somewhat steady rate at which US GDP had grown during the bull phase. His contention is that when the national income pie is growing at just 3-4 per cent it is unrealistic to expect that corporate incomes should be assumed to be growing at very high rates to warrant an upward revision in equity values.

For Robert Hall, however, such gyrations are entirely in line with changes in company cash-flows. He points out in support of market rationality, the phenomenon of the 50 per cent drop in valuation in 1973-74 at the time of oil crisis as entirely justified in the light of actual decline in cash flows that ensued. Prospects for cash flow growth of individual companies, in his view, are the key to understanding movements in the stock market. He goes on to argue that it is illogical to condemn astronomical price earnings ratios as irrational without investigating the prospects for growth in earnings.

Streams of future cash-flows growing at high rates are hugely valuable to shareholders, and it should hardly occasion surprise if investors are willing to pay a premium. Hall talks about technology stocks where the criticism of over-valuation was most pronounced. But even here, he points to the mistake made by the market in valuing Microsoft considerably lower than its intrinsic potential. A dollar invested in Microsoft stock in 1990 fetched $1.38 in after-tax earnings in 2000 alone.

It cannot be denied that the prospect of missing out on a potential Microsoft has probably driven most investors to bid up anything in the new economy. But a Microsoft notwithstanding, there have been mispricings galore. Both are right in their own way. Hall is right in contending that it all boils down to earnings growth rate and the feasibility of sustaining the required growth rate in earnings that current valuation of an enterprise warrants.

But Shiller is equally right about the `irrational exuberance' of investors when one considers that a vast majority of new economy stocks are way below their peaks. That cannot be mere coincidence. Synthesising the seemingly polar positions of Shiller and Hall, it emerges that valuation is a function of the current evidence on the prospects for a level of growth in earnings. If the evidence is reasonable, the earnings justify themselves. If, on the other hand, the evidence doesn't stand up to scrutiny, the values ought to correct themselves.

This is where management of companies whose shares are subject to mispricing by the market has a role to play. Such firms need to take the investor community into confidence by sharing their perceptions about what the business environment is like and the strategic options proposed to be adopted by them. This is particularly valid when a company's share price does not reflect what the management believes to be its intrinsic worth. The under-valuation could be due to market nervousness about the wisdom of a particular course of action a company might adopt. But the company's case might go unheard because it had not taken the trouble to present its side of the story.

Unfortunately, companies generally have an ambivalent attitude towards their share price performance. On occasions, they throw their hands up with a plea that market price movements are something that they do not understand. At other times, they seek to do some surreptitious manoeuvering with a clutch of friendly brokers. The usual ploy is to arrange for some seed capital to these brokers so that they can go ahead and rig prices up.

Till they are ready to hit the market with another public offering, promoters have only shown a benign neglect of the investor community. They do not believe they need to sell their shares to the investing community. Not in the sense of a public offering of shares, but in the sense of their representing an enduring store of value. That aspect of selling is something even FMCG majors with a reputation for excellent marketing seem to be good at.

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