Large caps are in momentum; be cognizant of valuations

Investing is more of an emotions play, and one tends to get caught by greed and fear. We at PMS AIF WORLD, recommend investors to be cognizant of this behavioral anomaly, when it comes to investing, so that informed decisions are made.

In this pursuit, we would like to highlight that though large caps are in momentum, one must be cognizant of high valuations.

Large cap indices like Nifty and its underlying businesses if valued at current price, in terms of the book value of their assets, valuations can still be justified, but if one values the same on the basis of earnings, look stretched, and one must be aware of the same while investing.  

Mid-Caps on the other hand may not be in momentum at the moment, but, are certainly in relative terms, valuations are attractive both on the basis of assets and earnings.

Because current liquidity bias is toward large caps, in near term, we may continue to large cap in momentum more over mid-caps.

However, traders may chase momentum, but investors, must chase valuations, and so, in our view, for new investments, mid-caps or multi-caps are more relevant over pure large caps.

Below mentioned are all current data point pertaining to Price to Book and Price to Earnings at levels, along their respective 3 year lows and highs for indicative comparison. We have also covered theoretical aspects of what is P/B and what is P/E, for investors to understand and make an informed choices.

Data as on 30th May 2019

Some Common understandings about P/E and P/B

1. P/B ratio for software / IT / FMCG companies – P/B ratio for these sectors is generally higher. The primary reason is these businesses have low tangible assets as compared to the total assets. So, P/B is used along with P/E to value fair value of the stock.

2. P/B Ratio for Automobile / Industrial / Oil and Gas Companies – Automobile companies generally have a Price to Book value ratio of greater than 1.0x. This normally happens because their asset book value tend to underestimate their replacement value. So, P/B is used along with P/E to value fair value of the stock

3. P/B Ratio for Banks – In case of Banks, since assets and liabilities are periodically marked to market, their assets and liabilities represent the fair value. Hence, P/B Ratio can be used for valuing banking companies stocks.

● Under ideal conditions, the price/book value (P/B) ratio should be close to 1, though it would not be surprising to find a P/B ratio of less than one for a bank with a large amount of Non-Performing Assets.

● It is also possible to find a P/B ratio above 1 for a bank with significant growth opportunities due to, say, its location, because it is a desirable merger candidate, or because of its use of technology in banking.

Thumb Rule

Overvalued: Low ROE + High P/B Ratio

Undervalued: High ROE + Low P/B Ratio