The Financial world is a great symphony, in which multiple asset classes interact to create a harmonious tune of wealth generation and risk diversification. Each asset class, whether equity, debt or real estate, has a distinct function to perform. These asset classes too have specific characteristics that affect their value. 

Valuation of “any asset class” is an interplay of only the following four factors:

  1. Return/Income – The return/income that asset generates
  2. Growth – The underlying growth 
  3. Discounting Factor – which in turn is total of
    •  Risk free rate of interest
    •  Risk premium – extra returns that the investor would require to compensate for the risk taken.
  4. Term/Tenor
    All the above eventually contribute to intrinsic value, but it is crucial to note that more uncertain and dynamic the variables, more intrinsic values are susceptible to the variables/assumptions used.Government securities have the fewest dynamic variables, while equity has the most.
Particulars Return Risk free rate Risk Premium Growth Tenor
G-Securities ✗ ✓ ✗ ✗ ✗
Corporate Bonds ✗ ✓ ✓ ✗ ✗
Equity ✓ ✓ ✓ ✓ ✓

Note: Since the coupon & tenor is known for the GSEC and corporate bonds, we have marked them as not variable above.

Let’s consider how sensitive these factors are which results in large variances in the intrinsic values with changes in these factors’ assumptions.

Government Securities: 

When investing in GSEC debt instruments, one is assured of the coupon rate that he will receive till maturity. Furthermore, because it is sovereign debt, there is no risk of receipt of coupon/principal. However, with the change in interest rates, the GSEC’ issued earlier, trade at a discount/premium depending on the differential in coupon and risk-free rate at that time. A 1% drop-in interest rate in GSEC with a duration of 6, will lead to ~6% appreciation in the Bond Value. 

Corporate Bonds:

When the identical debt instrument is a corporate bond, the coupon rate is fixed, but there is risk associated with the corporate’s solvency, resulting in a risk premium required over and above the risk-free rate. The risk-free rate or risk premium could change, causing the fair value to change. 

Equities
As an asset class, it has the most dynamic variables among the asset classes discussed above, and they all have an impact on their valuations. What makes it complex is the differing degree of assumptions and expectations about each of the four variables.

  • The returns (Profits or ROE) a firm will generate. Higher the ROE, better the valuation.
  • Growth, a firm will have over long period. Perpetual nature of equity makes it more complex, as one is supposed to make assumption for medium term and perpetual/terminal growth. Higher & more predictable growth will command higher valuation and vice a versa. That is why commodities command lower valuation than consumer companies.   
  • Cost of capital plays an equally important role in determining the intrinsic value that the company will have at various points in time. Again, the risk premium would differ depending on the quality of business, quality of management. That is what leads to a wide variation in the valuation market assigns to different sectors and within sector, different companies. 

Perception around these variables is what drives the asset prices all the time. While the interest rate variables affect the risk-free rate perception of market, the slowdown variables affect the growth perception. Whether or not there is an actual slowdown – the market perception and assumptions in place for different assets classes drive the valuation among these asset classes.

So, if you must take a view on the valuation, you must take a view on each of these factors i.e., ROE, Growth, Risk Free Rates and Risk Premium. 

View on each of these factors in the current context: 

ROE – India’ ROE profile has been better than most emerging markets for a long time. This itself is a significant starting point why it has traded at a premium historically. We see this either staying at current levels or marginally getting better. 

Growth – Growth perception and expectation keeps varying from time to time. During Covid times, it looked bleak. Today it is looking very positive. There cannot be a denial, that perception about India’s economic growth and corporate earnings growth is far better. Corporate earnings to GDP ratio for FY23 of ~4.1% is still in the middle of the cycle. Perception of India’s growth sustainability on a relative basis to all EMs (China, Brazil, Russia, etc) is far better. This surely calls for a higher premium to them than in the past.

Risk Free Rates – India’s interest rates compared to the rate cycle globally is one the lowest ever. The Spread between the US 10 year and 10-year GSEC is at 3.16% and difference between inflation is also the lowest. We believe that interest rates have peaked out.

Risk Premium – A country’s valuation is determined by the risk premium which is a function of how stable, sustainable the economic growth is. There can be no doubt with series of reforms being carried out in the recent past and along with balancing the economy with deep focus on manufacturing & infrastructure development, India’s and Indian Equities Risk premium is steadily reducing. At the same time, it has gone up for China thereby impacting valuation negatively.  

If each of these four factors are far better than any time in the past and better than any other markets, why should people question & worry about India’s premium valuation compared to the past and other EMs. If India were to trade cheap, one should worry. People who continue to believe in the narrative of current markets being expensive, may end up missing a big growth and wealth creation opportunity. We do not find the Indian markets expensive. Surely there are pockets of euphoria, which one should avoid, but not the markets.