Are valuations at further risk?

At best, earnings may grow at a compounded average growth rate of about 20% in fiscal 2009 and fiscal 2010

The price-earnings multiple of the Sensex, the Bombay Stock Exchange’s benchmark index, has dropped from as high as 28.6 times trailing earnings in early January to 18.3 times trailing earnings currently. But, despite this decline by a third, valuations are far from low, especially when viewed in relation to expected earnings growth. Brokerages have trimmed earnings estimates for the current year and the next year on account of rising interest rates and firm commodity prices.

(VALUATIONS ARE STILL NOT LOW)
At best, earnings may grow at a compounded average growth rate of about 20% in fiscal 2009 and fiscal 2010, and if interest rates rise further or commodity prices continue to rule at current levels, even these estimates are at risk.

For the Sensex, the price-earnings to growth, or PEG, ratio may be slightly below 1 at present, but for most of its constituents, current valuations are higher than the estimated growth in earnings for the coming two years. According to data collated by Enam Research, eight of the 12 sectors represented in the Sensex have trailing price-earnings (P-E) multiples that are higher than the estimated growth in the their earnings (see chart). The PEG ratio, which is arrived at by dividing P-E multiple by earnings-per-share growth, is widely used as an indicator of a stock’s potential value.

Some investors use the one-year forward P-E multiple and then compare it with the estimated growth in earnings to arrive at the PEG ratio. But as one fund manager points out, that would be a case of double counting the impact of future growth.
Using the trailing P-E multiple, only the metals and mining, oil and gas, telecom and IT services sectors are valued at a PEG of less than 1. The first two sectors have historically traded at low valuations because their fortunes are linked to commodity prices. In the case of oil and gas, there is the added worry about government intervention in pricing. And for both the telecom and IT sectors, PEG is only slightly lower than 1, and doesn’t really warrant a call for “value- buying”.
The engineering sector, which has the highest estimated earnings growth rate of 26% currently, trades at a valuation of as much as 38 times trailing earnings. For some other sectors such as auto and cement, the price-earnings valuation may look low when seen in isolation, but earnings growth estimates are even lower.
Going by the valuation of the Sensex constituents, there seems to be little upside for the index. What’s more, many Indian firms have adopted aggressive accounting policies in the recent past to buoy reported profit. In some cases, current reported profit may be inflated and hence the P-E multiple may seem lower than they actually are.

Fertilizer stocks: the proof of the pudding...
The Indian government has approved a new policy for the urea sector to tackle the problem of stagnant domestic production and encourage investment by Indian firms. Production from new units and incremental produce through debottlenecking of existing plants are promised higher realizations. Depending on whether the incremental production has come from greenfield or brownfield expansion, or debottlenecking, manufacturers will get 85-95% of import parity price, subject to a price band of $250-425 (Rs10,705-18,199) per tonne.

According to Enam Research, an additional 20% output through debottlenecking can result in a doubling of profit from current levels. Assuming a company goes in for a brownfield expansion and increases capacity by 50% (although this may take about two years to complete), profit could rise by three times. For brownfield expansions, some amount of expense incurred on gas transportation will be reimbursed, making it even more lucrative for firms to consider new investments.

Not surprisingly, fertilizer stocks rose by between 7% and 9% within three days of the policy announcement. Shares of Zuari Industries Ltd jumped by as much as 21% in the same period. But in the next two trading sessions, most fertilizer stocks gave up those gains. Only shares of Zuari have risen meaningfully (15%) since the policy announcement.

Some fertilizer firms seem to be wary about the availability of gas for the new plants. But some analysts believe the supply of gas from the Krishna-Godavari basin will address the gas shortage problem to a large degree.
The fact that the markets have disregarded that possibility and the potential for profits to zoom in the event of any expansion implies that the investors would rather wait and see if these firms actually go ahead with new investment plans.
Another reason for the lacklustre performance of the stocks, of course, is the bearish phase the markets are in currently.