Investors paying for earnings that don't exist

Investors are paying far higher than the actual earnings of the companies.

Even as the economy is in doldrums, equity markets are on the rise. This is evident in the price to earnings (P/E) ratio of bluechip companies which has been soaring of late. 

In a classic case of irrational exuberance of investors, the P/E ratio of the BSE’s bluechip companies is at its highest in at least the past 20 years during 2019-20, primarily due to the rally witnessed after Finance Minister Nirmala Sitharaman announced a corporate tax rate cut on September 20.

This, in essence, means that the investors are ending up paying far higher than the actual earnings of the companies. The P/E ratio of 30 companies listed on BSE Sensex stands at 27.4, higher than the 23.89 witnessed during 2000-01. 

For bluechip companies on BSE Sensex, the P/E ratio has gone up by 16% in the past six months from 23.71 in 2018-19.

The price-earnings ratio is defined as a company’s share price to the company’s earnings per share — in essence meaning the amount you pay for every penny of the earnings.

Analysts expect that once the tax cut takes effect fully, the P/E ratio is likely to moderate a bit. However, many others sound a note of caution.

“While sounding a cautious note on earnings, one of the things to watch for is a correction,” said Anubhav Shrivastava, partner at Infinity Alternatives.

Some others believe that it is the irrational exuberance by the investors that has led to this frenzy. Coined by former Federal Reserve chief Alan Greenspan, irrational exuberance refers to investor enthusiasm that drives asset prices up to levels that aren’t supported by fundamentals.

On the other hand, P/E ratios of small-caps and midcaps have declined by 40% and 16% respectively. The P/E ratio of the BSE midcap 150 stands at 25.85 as on date, while that of small-cap stands at 33.55.

This means that the gains in the markets have been highly polarised this year — a thing that was feared by many on Dalal Street. 

Since the day Sitharaman announced the cut in corporate tax rates, BSE Sensex has surged by 12% in two months — an annualised return of about 100%.

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