earnings growth, expected return

Nifty tanked 157 points yesterday, which is a 1.56% fall from the previous day. This happened after some time, and especially when people did not expect it. The market euphoria seems to be there still, although the index trades close to 26 times earnings now. 

What people do not understand is that there is a business behind every stock, and therefore, the index is nothing but a giant conglomerate comprising of 50 or more businesses. We cannot view the prices in isolation, for if we did, we will have esoteric numbers, which otherwise will be difficult to explain. 

A better way is to think about what we can expect from the current prices. If we expect Nifty to give us an annual return of say, 12% in the next 5 years, we will have to think about two numbers: earnings at year 5 and a multiple to apply at the time. Let's use a multiple of 20, which itself is not pessimistic, and 5 years from now the expected Nifty will be about 17500. So far so good. The catch, however, is that to achieve that the earnings will have to grow at 18% annually over the period. Is that doable? Yes, of course; but I always like to think in probabilistic terms. So how likely is that to happen? Well, a lot of things will have to fall in place before that can happen. It's been quite long since Nifty clocked that kind of earnings growth; very long. 

That is for Nifty. How about individual stocks? If the index can give a return of 12%, we would like returns from stocks to be at least say, 15%. Let's stick to that. The Nifty-50 stocks have been trading at different multiples, mostly unsustainable over longer period. If we can normalize the multiples, and then check how much earnings will have to grow to achieve our expected return of 15%, it should make sense. 

So here's the story for the 50 stocks within Nifty.

The blue line shows the current PE of each stock; and the red one shows our expected, a little more reasonable multiple. I have been careful not to assign a too low multiple. So I believe that the expected growth rate is on the lower side, rather than higher. Let's take for instance, Eicher Motors, which is trading at a PE of 50, and I have assigned an expected PE of 30. We can see how much the blue line is off the red line. 

When I analyze stocks, I pick all numbers from the reports published by the company. However, here for this exercise, I have relied on the external sources to pick current earnings and multiples. To the extent that it might have errors, the numbers could be unreliable. Yet, I believe that this should give us a fair idea about whether the growth in earnings is probable. Although book multiples are better suited for the financial stocks, we get the idea for them too.

Now we move to the expected growth in earnings:

As we can see, most of the companies will have to grow their earnings by more than 20% annually over the next 5 years in order for us to give a return of 15%, based upon our expected multiples. ACC, for instance, will have to grow at 47% annually; and Cipla, 37%. I have ignored Tata Steel, which has negative earnings, and the multiple did not make sense. Still, Tata Steel stock price will have to move from 654 to 1316 to give us our expected return. How likely is that? Or how likely is that these Nifty companies will be able to grow their earnings as pointed out by the chart? Will Zee Entertainment be able to grow its earnings by 24% annually?

PE multiples are also based upon the fundamentals of the business, which is driven by the cash flows, growth, and risk in those cash flows. The higher the operating and financial leverage, the higher the risk, and the lower the multiple. The more consistent the cash flows, the higher the multiple. But there is a limit to the multiple assigned because it is mostly dependent upon the growth in earnings and cash flows. The earlier we get it, the easier it becomes for us to check the market. 

If we are too quick to assign future prices to the stocks at present times, naturally we will have to tone down our expected return, which is what has happened now. Blame it on the guys on the street.