Bargain hunters beware. Do not rush into buy just because valuations are contracting as share prices fall. While valuations as indicated by metrics like price-to-earnings and dividend yield have corrected substantially, relying on such figures alone in the current scenario may not lead you to the right decisions.
Take for instance the PE ratio. If purely using trailing PE, the denominator reflecting earnings growth of trailing 12 months may no longer be reflective of the earnings reality amid the unfolding coronavirus-related economic shocks. The earnings profile of several businesses will be hit severely in the coming quarters. In this scenario, the PE will seem optically low as share prices have corrected sharply relative to the trailing earnings profile. In a few months, when actual earnings start coming through, valuations as seen today may no longer seem cheap. “Trailing earnings will not be relevant for 2020-21 earnings given the current pandemic and associated lockdowns. Equity investors and analysts will look at 2021-22 estimated earnings to value companies,” says Rajeev Thakker, CIO, PPFAS Mutual Fund.
Even PE based on forward earnings will give a distorted picture. The 1 year forward earnings growth assumptions will only be revised with a lag. Any revised estimates may also not be sanguine given the difficulty in quantifying the impact of such unprecedented dislocation to individual businesses. Sankaran Naren, Executive Director and CIO, ICICI Prudential Mutual Fund, reckons investors should look beyond earnings and instead focus on balance sheet quality now. “Earnings profile for next six months is irrelevant. Stick with the strongest players in their respective sectors based on inherent balance sheet strength.” Thakker argues, “Given the high uncertainty, in some companies, it may create an illusion of value but for most companies which have the capacity to comfortably survive the current downturn, the earnings and value will come back soon.”
Similarly, experts believe other metrics like dividend yield and price to book value may also be compromised. “Dividend yields on a trailing basis will be as misleading as earnings. There will be many companies that will cut dividends,” points out Thakker. Even the PBV metric may be useful only in some asset-heavy cyclicals and some financial stocks. For many sectors such as IT, pharma, FMCG, it may not be of much use.