Why Nifty isn't Cheap on P/B ratio

Currently Nifty is trading at a P/E of 26 X while the current P/B is 4x.

In last 10 years it had been observed that market had peaked at 25 -28X P/E and the P/B OF 5- 6X

Currently if we look at market it looks near the upper end of the valuation range if we look at P/E ratio which is 26X

But if you look at P/B ratio the market can still go up by 33% since the current ratio is 4X while market tops out at 6X.

There is an anomaly in the data since in last 10 years whenever the market went up to 28X PE the price to book value also rose to 6X

But today the PE is 6X while Price to book value is only 4X

I did some research to find out the reason for this anomaly.

If we look at the share capital of Nifty 50 companies in January 2008 it was total of 2,13,186 crs INR

Today the share capital of Nifty 50 companies stands at 3,62,553 Crs .

Which means that Indian companies have raised share capital to the extent of 1,49 ,367 crs from January 2008 to March 2010.

If we look at the market capitalization it was as follows

·         Market capitalization = Book value * P/B multiple

	Book value	P/B multiple	Market Capitalization
Jan-08	213186	5.95	1268459
Aug-10	362553	3.8	1377702
% Change			8.61%

Therefore we can see that the current market capitalization is already above the market capitalization in January 2008.

If we use this data to calculate the P/B if no additional capital had been raised than the current P/B value of the market is 6.42X which is already above the January 2008 highs.

	Book value	P/B multiple	Market Capitalizations
Jan-08	213186	5.95	1268459
Aug-10	213186	6.46	1377702
% Change

Thus the data supports the fact that markets are already trading at the upper end of the valuation range in last 10 years.

The lower current price to book multiple is also supported by the fact that the current ROE is 22% while the ROE in January 2008 was 30%

The ROE has decreased because of the additional capital raised by the companies.

Fallacy of strong balance sheet of US corporate's.

Off late we have seen a number of reports about US corporate’s sitting on net cash level of 1 trillion USD which is just waiting to get invested. The report emphasizes that once corporate’s starts investing the cash it will generate employment. 

I have done this analysis with objective to understand the balance sheet and debt position of US corporates. I have classified companies into three strata.

The first strata (Index companies) consist of 528 companies comprising of S&P500, DJIA and Nasdaq 100. The objective is to focus on the large corporations in US. 

The second strata consist of Non BFSI companies. The objective is to understand the debt position of the real sector excluding the BFSI companies. 

The third strata consists of 3000 companies consisting of Russell 2000,  S&P500, DJIA and Nasdaq 100.These strata represents the broad health of overall US corporate’s. I have further classified this data into two segments. Raw data includes companies like extremely high leverage (Fannie mae and Freddie mae) which distort the results, while the edited data represents the group excluding these highly leverage companies.

What I have observed is that most of the analysts are only reporting the cash in the balance sheet without including the debt on the balance sheet. We all know that this is an incorrect way of looking at company’s cash position. The best way to look at company’s cash is to look at net cash figure.

If we only look at cash in hand along with short term investment, the total cash held by US corporate’s (Non BFSI) is near 435 billion dollar.  But if we look at net debt or net cash position the total debt of US corporate sector is 7.11 trillion USD. 

Note: - Cash includes short term investment, long-term investment including investments in subsidiary companies.

Index companies

I have taken 528 companies comprising of S&P500, DJIA and Nasdaq 100. Companies with zero debt position are 47% of the market cap and 21% of equity.

Out of the total 528 companies only 160 companies have a negative net debt position having a net cash of 480 billion USD. Net cash to equity is 0.37:1 and Cash to market cap is around 0.14:1

Remaining 368 companies have a debt of 4.33 trillion USD having net debt to equity of 0.71:1. 

Overall net debt to equity of all 528 companies is 0.52:1.

Index Companies Data
	No of co.	Market cap	Net Debt	Equity	Debt/Equity	Debt/Market cap
Total Companies in Dow, Nasdaq 100, SNP 500	528	10667	3855	7315	52.70%	36.00%
Companies with Negative or Zero Net debt	160	3434	-480	1287	-37.00%	-14.00%
Companies with Debt	368	7233	4335	6028	72.00%	60.00%

Non BFSI sector

Looking at the non BFSI data we can say that the health of Non BFSI companies is little better. Companies with zero debt position are 32.5% of the market cap and 23% of equity.

Only 1154 companies are completely debt free and have total cash 435 billion dollars which is 32.67% of equity and 11.6% of market cap. 

Remaining 1374 companies have debt worth 2578 billion and have debt to equity ratio of 0.6:1

Overall debt to equity ratio for companies is 0.38: 1

NON BFSI Data
	No of co.	Market cap	Net Debt	Equity	Debt/Equity	Debt/Market cap
Companies with zero debt	1154	3752	-435	1332	-32.67%	-11.60%
Companies with debt	1374	7744	2578	4284	60.17%	33.28%
Total companies	2528	11496	2142	5616	38.15%	18.64%

  

All companies including BFSI sector

  

Continuing with my analysis I have taken 3000 companies listed in USA. .Companies with zero debt position are 32.1% of the market cap and 23% of equity.

I have presented two sets of data one is raw data and the second is edited data. I have removed nine extremely high debt companies like Freddie mae and Fannie mae as they were distorting the results. Therefore it’s better to focus on the edited data.

Only 1277 companies are completely debt free and have total cash 631 billion dollars which is 35.8% of equity and 14.4% of market cap

Remaining 1699 companies have debt worth 7742 billion and have debt to equity ratio of 1.3:1

Overall debt to equity ratio for companies is 0.92:1

    

All companies including BFSI - Edited Data
	No of co.	Market cap	Net Debt		Equity		Debt/Equity		Debt/Market cap
Companies with zero debt	1277	4386.92	-631.43		1761.98		-35.8%		-14.4%
companies with debt	1699	9258.87	7742.30		5919.00		130.8%		83.6%
Total companies	2976	13645.78	7110.87		7680.98		92.6%		52.1%
All companies including BFSI - Raw Data
	No of co.	Market cap		Net Debt		Equity		Debt/Equity		Debt/Market cap
Companies with zero debt	1278	4387.00		-631.43		1762.06		-35.8%		-14.4%
Companies with debt	1707	9275.82		13290.34		5937.97		223.8%		143.3%
Total companies	2985	13662.82		12658.91		7700.03		164.4%		92.7%

Conclusion

·         Index companies including BFSI companies have a net debt to equity ratio of 0.52:1

·         2528 Non BFSI companies are placed better with total debt to equity ratio of 0.38:1

·         2976 Companies including companies form BFSI sector (edited) are having a debt equity ratio of 1.3:1

·         Moreover it must be noted that the distribution of net cash amongst companies is highly skewed. Top 20 companies, holds 219 Billion of net cash which is almost 50% of net cash. While the remaining 1134 companies holds only 215 billion of cash. 

Therefore it’s a fallacy to say that the US corporate are debt free and they have substantial ability to invest in hard assets and generate new employment.