Earnings is key determinant of market returns in the long run
If earnings growth pans out as expected, we may even see a compression in market P/E multiple.
Equity market returns are made up primarily of two components, corporate earnings or earnings per share (EPS) growth, and P/E (price to equity multiple) expansion.
Sometimes, when the market is in the momentum phase and is driven by liquidity, a large part of the returns gets delivered by PE expansion, rather than by earnings growth. However, over the long term, it has been observed that earnings growth is the key determinant of market returns and has a good correlation with market returns.
For example, between FY01 to FY08 Nifty EPS growth was 21 per cent at compounded annual growth rate (CAGR), while Nifty50 index delivered 22.5 per cent returns CAGR over the same period — reflecting a good correlation between corporate earnings growth and stock returns.
However, in FY09, Nifty EPS fell by around 11 per cent, while the Nifty50 index delivered a (-) 36 per cent return, as sentiments were overly negative, and this resulted in a PE compression of 25 per cent.
From FY08 to FY17, Nifty EPS growth was only 4.5 per cent CAGR, while the Nifty index delivered 7.5 per cent returns CAGR. The gap widened as we completed FY18.
This has primarily been due to flattish growth in Nifty EPS that we witnessed over the past four to five years. Certain sectors such as metals, IT, capital goods, PSU as well as private banks and pharma have been key drags on earnings in the past few years, but they have started to turn around.
If we assume market consensus Nifty EPS at around Rs 471 for FY18, the Nifty EPS growth over the past five years (ended FY18) would be 28 per cent (absolute), while the Nifty index has delivered a return of around 85 per cent in absolute terms over the same period (up to Feb 2018).
This means that a bulk of the returns on the Nifty index (almost 67 per cent) has come from P/E expansion over the past five years, as the market ran up in anticipation of a corporate earnings recovery, and driven by strong liquidity.
From another perspective, we look at five-year rolling Nifty EPS CAGR versus the Nifty CAGR returns over the corresponding period. As seen in the chart below, you can see a decent correlation between the two parameters, although intermittently the index returns have overshot/ undershot the earnings growth trajectory.
In the short term, the market may get swayed by various factors like liquidity, news flow etc. (and be like a voting machine). But in the long run, the market will factor in the fundamentals (be like a weighing machine), and primarily reflect the corporate earnings trajectory.
With economic growth recovering, we expect earnings growth to pick up in FY19 and FY20 to around 20 per cent plus, and therefore market returns will be led by earnings growth going forward, rather than P/E expansion — like it has happened over the past 4-5 years.
If earnings growth pans out as expected, we may even see a compression in market P/E multiple, which seems relatively elevated at current levels. We expect sectors like private financials, metals, IT and pharma to contribute primarily to earnings growth going forward.