PE ratios may be about to take a hit, analysts uncertain

MUMBAI: With the Reserve Bank of India giving interest rates a consistent nudge upwards, the conventional assumption is that stocks have nowhere to go but down. Reason: interest rates and stock markets have an inverse relationship. When interest rates fall, investors are willing to pay more for future streams of corporate earnings. In other words, they are willing to put up with higher price-earnings multiples (PE).

On the other hand, when interest rates are high - as they undoubtedly are today - fixed income investments become more attractive to investors, and stocks begin selling at lower PEs.

The big question: is the Indian stock market now ready for a PE contraction?

In a recent note, Vision 2025 Asset Management puts forward a number of reasons why a PE contraction cannot be further avoided. As the report points out: “Rising rates lower the discounted cash flow-based fair value of stocks as future earnings and cash flows will be discounted at higher rates. Higher rates mean higher cost of capital - and hence they tend to impact corporate earnings in most cases. Higher rates mean lower gearing and higher cost for the consumer - and hence they tend to adversely impact consumer demand. Later, they tend to breed delinquencies in the case of bank loans”.

The note also says “If interest rates rise much faster than inflation, or if real interest rates start rising, then they serve as a disincentive to spend and incentive to save. That is bad for corporate India’s sales”.

Due to these reasons, the note comes to the conclusion that there will be “lower earnings per share (EPS) growth for Sensex companies in 2007-08 (15% Vs. 30% in 2006-07) and it looks difficult for the Sensex to avoid a further PE contraction”.

But not everybody agrees with this logic. “Today, at an EPS of Rs 820-830 for Sensex companies, the PE is at around 16 times. Logically, when interest rates go up, PE should come down. But whether things will happen logically is the big question,” says Soumendra Lahiri, senior vice-president, equities, DSP Merrill Lynch.

R. Rajagopal, head, equities, DBS Chola Asset Management, is among the skeptics.

“The markets move fundamentally on the earnings potential of companies. Though there may be a shock in the short term due to the rate hike, I don’t see a PE contraction happening as yet as interest cost as a percentage of turnover is coming down.”

Rajagopal says between theory and reality there can be a gap. “Though it is theoretically right to say that a rise in interest rates will lead to a contraction in PE, that can’t be commented upon until it reflects in the results of the next couple of quarters. We are expecting corporate earnings growth to be in the range of 15-20% for Sensex companies. That will put the PE for Sensex companies at 15-16 times. And the price/earnings growth (PEG) ratio will be below 1. As long as it is below 1, there is further potential for the markets to grow,” he adds.

Still others feel that the high interest rate scenario is a short term phenomenon and things will be fine by mid-year. According to Sanjay Sinha, head of equities at SBI Mutual Fund,

“The key question is for how much time this hardening of interest rates will continue. My expectation is that as inflation numbers come down by May on the back of the base effect, there will not be any case for a further hike unless crude oil continues to trade at higher levels. But crude has surged in the last few days largely due to the standoff with Iran. If that situation eases, crude should come down to $58-60. If that happens there will not be any case for a hardening in rates.”

Sinha adds: “There is no major slowdown in credit growth. Banks have indicated growth of 20-25% in 2007. In this scenario, I actually see rates coming down in the third and fourth quarters of calendar 2007 as corporate earnings will continue to surge on strong demand.” Ajay Padwal, vice-president - PMS, Mehta Equities, says talk about a PE contraction is premature.

“The markets are in a correction mode and to talk about a PE contraction is too early. Ultimately, the government is interested in controlling the demon of inflation. Last year, the nominal growth was at 13-14% and, with a benign inflation of 5%, we clocked a real growth of 8.5-9%. But with rising inflation there is a fear that real growth will come down by 1%. Keeping the long-term picture in mind, interest rates at these levels are still fine. Earnings may get affected if there are a couple of more hikes. Then the PE contraction may happen”

Some experts feel that demand will not be affected by rising interest rates because India is a service economy now.

“The main difference between the scenario in 1995-96 - when high inflation and high interest rates hit demand and growth - and today is that demand is now driven by rising income in the hands of individuals. Today we are a service sector economy and salaries have gone up by 13% last year. As income levels continue to improve, I don’t see any problems on the demand side. Improving supply side dynamics should be the priority,” adds Sinha.

To sum up, there’s little doubt about India’s long-term growth story.

However, the question is whether RBI’s policy measures (interest rate hikes and controlling liquidity) will lead to the desired results (lower inflation) or merely “slam the brakes” on the growth story. The next few months should surely provide the answers.

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