Monday, August 2, 2010

A View to the Nifty Fundamentals ... !

  Does Inflation Affect the Nifty Valuations ... ???

The return of galloping inflation isn't  news anymore ! It's been here with us for the last year or so. Last week, the RBI too felt that inflation needs to be controlled after being fallen behind the curve in inflation targeting. ( Click here to read this blog's take on the last week's RBI action ). And the Opposition parties too got the price rise  weapon to attack the government. Some analysts are even projecting a further rise of 100 basis points in the repo and reverse repo rates in the current financial year.

As a consequence of the RBI action, the interest rates in the economy will rise. Now the question is whether rising inflation is capable of affecting the Nifty valuations ? A Google search reveals a scholarly paper by  Steven A. Sharpe,  which says : " a rise in expected inflation coincides with both (i) lower expected real earnings growth and (ii) higher required real returns."

Now let's translate this to our kind of simple language. Let's start with the word 'real' from the above quote. Last week this author commented that if one year deposit rates are yielding less than the inflation rate, the 'real' interest is actually negative. Say a deposit earns  8 % and the inflation as per the whole sale price is 15 %. The depositor makes the deposit by postponing a buying decision which can be executed at a price of 100 rupees at present. She gets 108 rupees at the end of one year, whereas her purchase then  requires her to spend rupees 115. It seems that  she has made a loss of rupees 7 by making the deposit. This loss is called negative real interest. Now what could be the real interest ? Real Interest  = Actual Interest - Inflation. And it is supposed to be on the positive side.

Now even if the Nifty companies could register a profit growth of 25 % for the current financial year, how much of that profit growth is 'real' if we assume a 15 % inflation rate ? 25% growth minus  15 % inflation leaves  a  'real' profit growth of 10 % only. We have already explained the first part of the quote. Inflation affects not only the depositors but also the stock investors.

Now how can we explain the second part of the quote which talks about  "higher required real returns". The answer is simple. How can we increase the returns of an investment in stocks ? Buy at much  lower prices than the prevailing prices. How is it possible ? Simple ! Since the prevailing prices are higher and do not give adequate real returns, it should fall.

A View to the Nifty Price Earnings Ratio

The NSE website says that the Nifty index has closed at a Price Earning multiple of 22.91 as on 2nd August, 2010. Here is a snapshot of the page !

What does a Price Earning ( P/E Ratio ) multiple mean. It means that the Nifty price is 22.91 times the Nifty earnings. We know the Nifty price. It closed at 5431.65. If this closing price is 22.91 times earnings,  how much is the Nifty earnings. 5431.65/ 22.91 is Rs 237.  

The beauty of the PE ratio is that it helps us to find out the rate of return (  i.e. earnings )  of the Nifty or any stock in comparison to the asking price just like we calculate the interest. Therefore, the current rate of return of Nifty is 4.36 %. ( 237/5431.65*100 = 4.36 % ).

However, there is also a short cut available to the above calculation. The current rate of return of the index or stock can also be calculated by dividing 100 directly by the PE Ratio. Now lets do the calculation : 100 / 22.91 =  4.36 %.

The pertinent question now is... does it make sense to buy Nifty at a current yield of 4.36 % when the inflation is reaching the lower double digit levels ?

Here are the parting words : Enjoy the rally till it lasts ! Growth chasers ( read FIIs ) enabled  by the extended loose money policies of the outside world may stretch the rally too. But stock prices are not cheap. Let the buyers beware !!
Additional Disclosure : The author is neither an expert nor an economist. This article is based on pure common sense. The author takes the responsibility of any mistakes in the analysis too, on the condition that this article shall not be considered as investment advise. 

Click here to read an article on historical valuations of the Nifty Index.

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