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Is the broader market getting overvalued?

| November 24 2014 08 : 15 IST | LiveMint.com
The Indian stock market, as reflected by the S&P BSE Sensex, has gained about 40% in the past one year and is trading at levels close to all-time highs. Change in sentiments has led to big gains in the broader market, and the sharp upward movement in stock prices has also pushed valuations for many companies. The BSE Mid Cap and Small Cap indices have gained 65.46% and 89%, respectively, in the past one year.
 
At any given time in the marketplace, there are gainers and losers. Naturally, in a bull market, the number of gainers is much higher than that of losers. Sample this: Of the 1,000-plus companies listed with market capitalization in excess of Rs.250 crore (as of 20 November), over 900 have seen price appreciation in the past one year. Further, among the gainers, over 400 companies have seen their stock prices at least double in the same duration.
 
Stocks overvalued?
 
In a bull market, when stock prices are rising for majority of the companies, there is a chance that in some cases prices move ahead of fundamentals and valuations get stretched. Differently put, some stocks get overvalued as investors look for maximizing gains in a rising market. Stocks are normally termed overvalued when the price appreciation is much higher in relation to the current or expected earnings of the company.
 
In the past one year, while the price-to-earnings (P-E) ratio for CNX Nifty has gone up from 17.71 to 21.7, individual companies have witnessed valuations getting pushed up significantly. For example, among companies commanding market value of over Rs.250 crore, Gati Ltd has gained over 900% in the past one year. The stock is now quoting a P-E multiple in excess 87 compared with 10.29 a year ago. Similarly, Hitachi Home and Life Solutions (India) Ltd has gained over 600% and P-E has expanded from 18.42 to 41.78.
 
Does this mean that valuations are getting stretched in the broader markets? "Yes, there are pockets of overvaluations in the market," said Kishor P. Ostwal, chairman and managing director, CNI Research Ltd, adding that too much money is chasing too few stocks and people are holding on to expensive stocks because markets are rising.
 
But, in the current context, not all are convinced that stocks are getting into the overvalued territory. "Valuations were depressed for many years and it is now catching up. And there are lots of stocks that still have to catch up," said Prasanth Prabhakaran, president (retail broking), India Infoline Ltd. But investors will have to be stock specific while looking at valuations, he added. The balance sheet of the company has to support the valuation. If the stock has become overvalued, the investor should sell it and look for companies that are available at reasonable valuations.
 
Since the economic environment is expected to improve, stocks have run up in anticipation of earnings improvement, which may or not come over a period of time. Therefore, it is important that investors keep revisiting their basic assumptions behind buying the stock.
 
There is, however, another angle to P-E expansion for some stocks or sectors as a whole. Valuations may have gone up for a reason. "There are pockets in the market where prices and valuations have gone up. There are sectors such as fast-moving consumer goods (FMCG), pharmaceuticals, and information technology where it may look like the valuation has gone up, but it may be because these sectors got re-rated," said Devang Mehta, head (equity sales & advisory), Anand Rathi Financial Services Ltd. Re-rating basically means that the market is willing to give a higher P-E for a stock. This normally happens in a rising market. But, surely, not all stocks are moving in anticipation or as a consequence of a re-rating.
 
Risk of overvaluation
 
When the price of a stock is way higher than what the current and expected earnings can justify, there is a fair chance that it might fall. At times, investors buy stocks simply because either the company or the sector is the flavour of the season, and they get trapped when the tide turns.
 
It is very difficult to sustain lofty valuations for a long time. However, there is no hard and fast rule that will tell you that the stock is overvalued and will fall after a particular point.
 
It is also important to note that overvaluation does not mean that there is something wrong with the company. It's purely a market phenomenon. Also, depending on the size and nature of business, valuations can differ for companies.
 
Mint Money take
 
The stock market has gone up in anticipation of earnings improving over a period of time. However, expectations, at times, push stock prices too far up. This is not to suggest that the entire market is overvalued, but valuations have gone up significantly for many companies, especially in the broader market.
 
Investors will do well to keep an eye on the actual earnings performance of a company in relation to its price performance. If earnings are not in line with rising stock prices, it's time to get out. It is always difficult to make such calls as the stock prices may go up further in a bull market. Conventional wisdom says that you should not be holding overvalued stocks, but in a bull market, there are few takers for such thoughts.
 
Source: Live Mint

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