Are current price-earnings multiples sustainable?

By Ashutosh R Shyam

India has been second only to Turkey among major equity markets in price-earnings (PE) multiple expansion since the start of 2014. The PE ratio tells investors how much they have to pay for a share for every unit of profit. Since the beginning of this year, Indian markets have gained 27 per cent.

According to a Barclays report, while earnings growth estimates support just 7.4 per cent of this, 19.2 per cent has gone into PE expansion – meaning stocks have become pricier without corresponding growth in earnings.

Interestingly, other top-performing equity benchmarks on a year-to-date basis such as S&P 500 of the US and Brazil’s Bovespa have gained, mainly supported by earnings growth.

A sift through the last two, 7-year equity cycles over the past 15 years indicates a strong connection between market returns and earnings growth.

Historically, whenever there is disconnect between the PE multiple expansion and earnings growth, it has either been supported by a late recovery in earnings or has happened after the PE multiple sustained a massive compression the previous year.

Otherwise, PE multiples have witnessed a collapse in the following year.

The PE multiple of the BSE-100 has expanded for eight out of the past 15 years, mainly supported by earnings growth. In the last equity cycle during 2005-07, the BSE 100 showed earnings growth of 15 per cent, 17 per cent and 30 per cent, respectively, which resulted in PE multiple expansion of 20 per cent, 19 per cent and 33 per cent.