What is the fair value of Nifty?

If we look at the historical valuation of Nifty during the last twelve years, we can see that Nifty has topped out around 25 – 27 times trailing twelve months P/E, while the price to book value at the upper end has been 5 times.

Similarly Nifty bottoms out around 2 times trailing twelve months price to book value while the price to earnings ratio at that level is around 10.

Currently Nifty is trading around 23 times trailing twelve months earnings which is almost very near to the upper end.  Similarly the trailing twelve months price to book value multiple is around 4 times.

We use the historical valuation level to project index level. Here I have used a discount of 15% in valuation multiple due to the following reason.

1.       Banks have a 17.5% weight in index. During the last Bull Run Banking sector was trading at a astronomical valuation of 5 times book value and 28 times earnings. I think that markets won’t support such astronomical valuations again due to structural change in the working environment of the banking industry after the global financial crisis.

2.       The current global macro environment is fraught with risk. US is expected to grow at average GDP growth rate of 2%, Europe is expected to grow at a modest GDP growth rate of 1% or less, Japanese economy is already stagnant and there is huge risk of Chinese economy slowing down to 8% growth in second half of the year. More over data from Chinese markets also suggest that a huge housing bubble may be in formation, which may burst to create a major negative impact on global asset prices.

Nifty should top out at around 6200 levels using historical multiples. Therefore we can see that the upside in the market is quite limited.

Following is the historical chart of ROE (Secondary Axis) and Price to book value on the (primary axis). From this char t we can see that the current ROE of Index companies is at around 22.5 which is significantly lower than the previous peak of 30.

As we all know that assets generating superior ROE demands higher book value multiple. The current ROE of index therefore demand lower price to book value multiple since its generating a lower ROE.

To ascertain the P/B deserved by the current level of ROE generated by the companies, I used the linear regression model using ROE as an independent variable and P/B value as a dependent variable. The data i have taken starts form 1st January 2001 to 16th August 2010.

The alpha of the series is 1.893 while the beta is 0.05. Following should be the price value multiple of index at at various level of return on equity.

Projected P/B @ ROE of 15	2.621
Projected P/B @ ROE of 18	2.766
Projected P/B @ ROE of 20	2.863
Projected P/B @ ROE of 22	2.960
Projected P/B @ ROE of 24	3.057
Projected P/B @ ROE of 26	3.154
Projected P/B @ ROE of 28	3.251
Projected P/B @ ROE of 30	3.348

Since the data is not perfectly linear there is always a margin of error when we use such forecast. But this regression analysis suggests that at current ROE of 22.5 the fair historical price to book value for Index should be 3 times.

The current book value of Nifty is 1401.28. therefore the fair value of index should be around 4203. which Again suggest that Index at this point is time is richly valued.

Here we can see that the risk reward ratio for an investor is currently 4:1. Therefore the current markets are not suitable for long term investments.

Similarly if we look at the other indexes we can see that the upside potential is limited. The worst risk reward ratio is offered by the IT sector which is currently trading at 24 times price to earnings and 8 times book value. According to historical valuation matrix the downside in IT stocks can be in excess of 60%

More over IT companies cannot grow at 30% year on year due to their linear business model.  On an average the expected growth of IT companies will be around 12 -14% which implies that IT companies are trading at a PEG ratio of 1.5 to 1.7 times which is extremely high.

Overall I believe that the currently markets are richly valued and the global macro environment is fraught with risks. Any negative news emancipating form US, Europe or China can cause a severe correction in Indian markets.