Nifty stretched or undervalued? PE multiples will shift higher, says ICICI Direct; sees 13% upside

After having jumped 91% from March lows, Nifty is now trading near all-time high. This multi-month rally in the 50-stock index has turned the spotlight on valuations. However, domestic brokerage and research firm ICICI Direct said that comparing PE multiples in isolation will not spell out the correct direction or assessment as to whether Nifty multiples are stretched or undervalued at this juncture. The brokerage firm said that taking into account the wash-out performance of India Inc in the first and the second quarter of the current fiscal year will deflate the real earnings.

Change in Nifty constituents

Analysts at ICICI Direct believe TTM PE (trailing 12-month price-earning ratio) and forward PE will shift to higher orbits; the primary reason for it stems from the change in Nifty constituents in the past decade. The report added that between March 2009 and December 2020, the weightage of sectors such as Oil & Gas, Construction, Metals and Telecom has fallen from ~60% in 2009 to ~20%. On the other hand, the weightage of sectors such as Financials, FMCG, IT, and Pharma improved from ~30% in March 2009 to 70% now.

“The change in contours in the Nifty composition logically shifts the PE orbit as well. This is well corroborated by the fact that trailing PE of Nifty in 2009-2014 averaged 17.1x. The average current PE multiples further expanded to 20.9x as the share of capital-efficient sectors such as FMCG, Financials, IT and Pharma have performed well,” they said.

Better performance not captured

Along with this, the preference for earnings visibility and consistency have helped capital-efficient sectors gain weightage, and hence trigger further push in PE multiples. Further, supporting their argument, analysts at ICICI Direct said that better performing business segments within existing companies is not captured by current PE multiples. “There are 9 companies in the Nifty, contributing 32% weight, wherein valuations are based on Sum of the Parts (SoTP) methodology,” they said.

Taking the example of Larsen & Toubro, the report noted that segments of the firms like IT are growing much faster than the core business and hence attract higher PE multiples. “So on a consolidated basis, the PE of the overall business will be higher than PE ascribed to core infra and engineering business,” they said.

Nifty target increased

Assessing the Nifty’s PE on a bottom-up basis, on the expected earnings performance and individual target prices assigned for each stock, ICICI Direct has arrived at a forward PE of 26.2x FY23E basis. “Hence, in order to arrive at a fair value on the bottom-up basis, we take a 10-15% discount to our weighted average PE of 26.2x in order to account for future earnings downgrades and any other unforeseen macro risks which might risk earnings to come at a target PE range of 22x-23.6x,” the brokerage firm said, consequently arriving at a fair value of 16,300 for Nifty in the next 12-18 months.

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