The second quarter earnings season has come to an end. We decided to have a look at how the companies are faring and if the valuations are in sync with the reported earnings.
The chart below shows the median sales growth across BSE 500 (Non-Financial) companies. The median has been used to get a better assessment of the health of companies across the board without getting influenced by size. A pessimist would say things are extremely bad, an optimist would say things can only get better from here as sales growth is close to -2 SD levels. A rational investor should evaluate such information with what has been factored into the valuation. If the worst case is factored into the valuation then it might not be a cause of worry.
Chart 1: Median Sales Growth
Thus the next step is to look at valuations. We have calculated the BSE 500 median PE (Chart 2 below). Median has been used again to get the true sense of the underlying valuation rather than getting affected by market cap. As can be seen in the chart, the valuation of BSE 500 companies seems to be at its highest historical level and is close to +2 SD levels.
Chart 2: BSE 500 Median PE
One could argue that profit margins could be depressed and thus valuations might seem high when you evaluate them on a Price to Earnings ratio basis. But even if we look at the Median EV to Sales ratio which would ignore the cyclicality of margins, the overvaluation relative to history is still clearly visible (see Chart 3 below).
Chart 3: BSE 500 Median EV to Sales
Thus on the one hand you have one of the worst sales growth in available history, and on the other you have one of the most expensive valuations which have led to a widest ever divergence between fundamentals and valuations. Within the broader market the valuation extreme seems to be even more in the Midcap and Small cap space (as seen in chart 4 below).
Chart 4: Midcap & Smallcap Median PE
The market seems to have already factored in a sharp recovery in fundamentals of these companies. Thus, even if a sharp recovery occurs it should not necessarily benefit the investor in terms of stock price increases. Secondly, in the situation where sales growth fails to meet the high (priced in) expectations, we could witness a sharp correction in the valuations.