Unprecedented Bull Run? Counter View

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This bull run has been nothing short of historic in terms of the public outcry it has generated. Almost every expert (at least  all value investors) globally and domestically has been shocked by this meteoric bull run. The latest GDP figures might be deep in the red but the market is close to all time highs. The RBI governor couldn’t resist commenting on the dichotomy either and he was firmly in the “markets are being  irrational” camp. But yet, markets don’t seem to care. Momentum investors are making hay while the sun shines while value investors sit in cash and gold waiting for the eventual crash. After all, it’s a matter of when and not it right?

Market Efficiency & The Wisdom of Crowds

Market efficiency, a concept championed by renowned American economist Eugene Fama basically states that all public information is already incorporated into the stock price. While teaching his security analysis class in Columbia business school, Paul J introduced a fun experiment. He asked his class of 46 students to guess who could win the Oscar in each of the 12 categories. In addition to recording each response, he recorded the median response for each category and designated it as the consensus estimate. He found that the consensus estimate (75%) beat the best individual estimate (67%). Paul J conducted this experiment for a few more years and found the same result. The consensus beat the individual everytime.

The wisdom of crowds is key to market efficiency. But the wisdom of crowds can turn into the madness of crowds if there is a diversity breakdown, i.e. investors are biased by certain factors. Behavioural aspects like greed and fear are generally the reason behind these breakdowns and while they occur often with individual stocks they are rare in terms of the whole market. Thus any bet against the market should be made with caution.

Indian Markets Valuation: Nifty 50

While individual equity valuations are common, how do you value an entire market? In this case, the nifty 50. While there hasn’t been a V shaped recovery for the economy, there certainly has been for the market as can be seen below:

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For my market valuation I need to come up with the following:

  • Individual and Aggregate Free Cash flow to Equity
  • Impact on growth due to the coronavirus pandemic
  • Long term growth once the effect of the virus subsides
  • Cost of Equity

Let’s go one by one.

Individual and Free Cash flow to Equity:

The cash flow to equity investors is generally measured through dividends or stock buybacks. However given that companies don’t pay out everything that they can and like to keep cash, most of the cash flows to equity investors are residual in nature. Hence to arrive at free cash flow to equity I used the cash flow from operations after capital expenditure and net debt payments. The cash flow from operations accounts for depreciation and working capital changes. After calculating the individual cash flows we need to calculate the aggregate cash flows for nifty 50. This is done by dividing the aggregate cash flows to equity by the aggregate market cap and multiplying it by the nifty 50 price at that time. The detailed numbers and calculations are given below:

Impact of Coronavirus on Growth:

GDP shrunk by 23.9% in the latest quarter. While the numbers might be alarming, quarterly numbers can be volatile. The strict lockdown for a month meant that this was to be expected. Yet, considering that several sectors of the economy like hospitality and air travel will take time to come back to pre-covid peak we need to tread with caution. In my valuation, I estimated no growth for the next three years. I basically assume that with all the fluctuations and volatility we will be back to where we were pre-covid in three years’ time. 

Long Term Growth post Covid-19:

Considering I have to predict the growth rate for 50 stocks, I cannot deviate too much from the aggregate economic growth for the entire market as a lot of above average growth stocks will be cancelled out with a lot of below average growth stocks. Considering a lot of pent up demand and high scope of growth considering very low per capita GDP, I estimated a compounded annual growth rate of 7% from years 3 to 15. Post year 15, I estimate most of my companies will become mature companies and grow at below the rate of inflation at 3%.

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Cost of Equity

I used the CAPM to compute my cost of equity:

Cost of Equity= Risk Free Rate + β*(Equity Risk Premium)

The yield on the ten year government bond is currently 5.93%, which serves as my risk free rate. The equity risk premium is the premium that I charge for investing in equities. Equity markets are extremely volatile and equity investors are the last in line in case of bankruptcy. Hence they must charge a premium for taking the additional risk. Most high rated long term corporate bonds are trading at 7 to 7.5% which indicates a spread of 1 to 1.5%. Most bonds of public sector undertakings are even lower. Hence an equity risk premium of 4.5% seems prudent. Beta measures systematic risk. Considering the nifty 50 index has 50 stocks from different industries, beta in this case is 1. My cost of equity comes out to be 10.43%.

I now have all my inputs for my market valuation.


The next part is pretty simple. I predict future cash flows based on my growth rates and discount them back to the present at the cost of equity. The sum of all the cash flows discounted to the present is my value for nifty 50. The valuation sheet is given below:

The value that I get for nifty 50 is 12102.54. 

Implied Equity Risk Premium

Similar to corporate bond credit spreads in fixed income, implied equity risk premium measures the risk that equity investors charge for investing in equities. It is the cost of equity for which the value of nifty will be its current market price i.e. 11,417. Plugging in the values, I arrive at the implied cost of equity fof 10.82%. This gives me an implied equity risk premium of 4.9%. Aswath Damodaran, professor at the Stern School of Business at New York University calculates the implied equity risk premiums for US markets using the same technique as described above. He has been tracking it since 1960. In the last 60 years, an implied equity risk premium of 4.9% is at the 70th percentile of all equity risk premiums each year. It would seem from the data that the Indian equity market has priced in enough risk. 

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As mentioned earlier markets are a product of the wisdom of crowds and hence very difficult to beat unless there has been a diversity breakdown. Hence, any bet against the market should be made with caution. Markets might still be overvalued, but there is certainly a case to be made that they aren’t. 

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Himanshu Sinha

Himanshu Sinha

Himanshu is hugely into Value Investing, Complex Adaptive Systems, Business Analysis, Behavioral Finance, and Spotting Market inefficiency.
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