Sunday, April 02, 2006

Sensex or NonSensex? Part II: Is the Indian Stockmarket Overvalued

We considered whether the Indian stock market, or rather its indicator-the Sensex, was overvalued or not in the last posting. In this posting we continue looking at other indications that could throw light upon the value of Sensex and the Bombay Stock Exchange.

Since any investor has the option to either invest in equities or bonds or numerous other instruments it makes sense to compare the current yields of these instruments to find the more attractive investment avenues. Consider the Govertment security bonds (G-Secs).

These bonds could be termed riskless investment options since they are backed by the Government of India. The current yield for these bonds is about 7.4%. So if this is the riskless rate of return, how much is the yield of equities?

There are two kinds of yields when we discuss equity instruments. One is the dividend yield and the other is the earnings yield. The dividend yield on Sensex today is definitely way below 2%!

Earnings yield on Sensex is also in the range of 5% or less. For most stocks on Sensex it is in the range of 1.3% to 3.3%! And note that stocks are definitely more risky than Government Securities. So how and why are these stocks considered as attractive investments as compared to G-Secs?

The answer is that G-Secs will continue providing the coupons that are promised on them till maturity and the principal on maturity. Whereas, the Stocks can appreciate in value and provide higher earnings next year and years after that. If that happens then the earnings yields would improve and also if the stock price goes up then the "maturity value" of the principal would also increase.

(Of course, we understand the above description might not be too kosher for the veteran investor, but that is an easy way to compare stocks and bonds.)

In any case, it seems that given the positive outlook a case is being made out to invest in stocks even when the current yield is not even half or in some case one-fourth of what can be obtained risk-free on G-Secs. Normally, stocks should provide higher yield as compared to bonds since there is a risk premium required from stocks which are inherently riskier as compared to bonds.

As we have demonstrated above, we think the huge differential between the yields of bonds and stocks is another indication that the Indian Stock market and specially the Sensex and other leading indices are overvalued by a huge amount.

Clearly, we expect a correction. We ask the investor to tread with caution. There are opportunities for the mature investor but the beginner should be very very careful in his selection of particular stocks or even investing in mutual funds.


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