Nifty closed at 9217.95 on 24 April. Can investors continue to buy the market at this rate? If we are talking about periodic investments in the index itself over a very long period, my response is always yes. There is no need to play the timing game here, for we are never good at it. Periodic investment of a fixed sum usually takes care of pricing per unit, which tends to average out. This is a low risk investing strategy resulting in very close to market returns.
Absolute investment in Nifty today is a different matter. That's 23.41 times earnings, and 3.52 times book equity. At least two factors affect investing in the index now: Earnings (actually cash flows) and market pricing at the time of exit. How much can earnings grow from here in the next 5, 10 or 20 years, and what pricing would it deserve at that time determine your return over the period.
It is easy to remember that the higher the expected earnings growth, the higher the multiple accorded. Yet, there are other factors affecting this pricing. In fact, there are mainly three: cash flows, growth rate, and risk in cash flows. When expanded for instance: Higher payouts usually result in higher multiples. It is also true when the business earns a high return on capital. When interest rates are low, stocks are priced higher. High debt ratio brings down the multiple. Stable cash flows bring it up. Then there is the ubiquitous market bias.
Instead of being part of the euphoria surrounding market, it is better to have a look at what has happened in the past, and think about what will trigger future. Usually, intrinsic valuation based on cash flows and growth rate is the best way to look at value. However, estimation errors are pretty significant there, so let's settle for what would be the implied rate of return.
Over the last 10 years, Nifty earnings grew at an annual rate of 8.39%, and for the prior year it was 7.10%. As we can see in the chart above, the 5-year earnings growth during the last 10 years was between 6.05% (for the year 2016) and 11.77% (for 2014). In fact, for the preceding year, the growth rate was the lowest. Are they ready to rebound?
If I want to look at investing in Nifty for the next 5 years, I will have to estimate earnings for the year 2021. What is the reasonable rate of earnings growth in the present scenario? Of course, there is the India shining story, but what if it does not turnout as expected? We can use a range from say, 5% to 15%. Then we need an exit multiple for the earnings. I will use 15, 20 and 25.
At 5% growth rate, I don't think investing is worthwhile even at a multiple of 25. Unless you consider that a post-tax return of 6.53% is difficult in alternative opportunities. Even when earnings grow at 15%, but index priced at 15 times earnings, the implied rate of return is less than ordinary.
It is only when Nifty earnings grow at 10% in the next 5 years, and it gets a pricing of 25 times earnings, or grow at 15% and priced 20 times, the implied rate of return is close to 12%. Do we want it? Of course, there is an additional 1.25% dividends. When earnings grow at 15%, and the index is priced 25 times, the implied rate of return magically increases to 16.67%. This is definitely not bad considering available opportunities at the moment.
Yet, the pricing multiple is subject to heavy bias. We are not sure of a higher multiple five years hence. At least that much risk is inherent in our expected returns.
My thoughts are with the conservative investor who wishes to remain in the investing game, but does not want to take undue risks. We are thus back to, our favorite, index investing. Keep throwing cash beginning of each month to buy available units of the index. When done over 15 to 25 years, there should not be much reason to complain, provided our conservative investor has had fun doing things that are preferred in life.
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