Prognostic Diagnosis of Indian Stock Market

There are many approaches to determine the valuation of the market or a stock. There is the capital asset pricing model, comparison with G-sec yields, Buffet’s market capitalization to GDP ratio or the popular earnings multiple approach, to name only a few.

The last approach mentioned above, draws attention to two crucial variables, namely earnings per share (EPS) and the multiple, that is price divided by EPS known as the PE multiple. Let us assume that a company’s share earns Rs 10 and the market after considering its growth potential gives it a multiple of say, 20. The price of the share in the market would then be Rs 200. It is much like the formula for calculating the area of a square. If each sides measures say, 10 feet, the area of the square would be 100 sq. ft. Now, if the length of the side is doubled to 20, the resulting area is more than double increasing four times to 400 sq ft. It is the same relation between earnings (EPS) and multiple (PE). Current earnings (EPS) for Nifty are, Rs 1138.07 and as of 20.08.2025 the PE multiple stood at 22.01. So, the value of Nifty would be 1138.07*22.01=25049. It is essential to bear in mind that of the two variables, the real anchor is the EPS. The PE multiple, among other things, is a function of the prevailing sentiment which can be fickle.

Central banks are generally quite circumspect when they express their assessment of the capital market of a country. But the latest Financial Stability Report (FSR) of the RBI points to the fickle nature of the PE multiple. The FSR states that Indian equities are trading at valuations increasingly disconnected from India’s macroeconomic and corporate realities. According to the FSR, the Nifty Midcap 100 and Smallcap 100 need annual growth of 28% and 30.6% to justify current prices compared to the projected earnings growth of just 17.4% and 16.9%. Even Nifty 50, the blue-chip index warrants 14.4% growth compared to expected growth of only 10.4%.

Going by Buffet’s valuation measure of market capitalization to GDP ratio, Indian stock market is in the overvaluation zone with the ratio as of 31^st March, 2025 surpassing 140%, well above the long-term average 89-90%.

Dividend discount model estimates offer additional insight. The Nifty 50’s expected dividend growth rate, implied by current prices and payouts, is 11.25%, closely aligned with its actual 10 year growth of 11.51%. However, to justify the current valuations, the midcap 150 and smallcap 250 require expected dividend growth of 20.10% and 19.84% respectively, far exceeding their historical averages.

This disconnect between euphoric expectation and fundamentals is brought about by a combination of structural and behavioural factors which are at play. First retail participation, especially in derivatives, has surged. According to a SEBI study, individual investors accounted for over 40% of index options volume in 2024, up from just 2% in 2018. This trend has arguably increased volatility without improving price discovery. Second, institutional flows have become more bifurcated. While FPIs, typically sensitive to valuation signals and global developments impacting investment risk, turned net sellers, domestic institutional investors, fuelled by liquidity infusion by domestic investors, substantially through SIPs that are valuation agnostic, continued aggressive purchases. The substitution of valuation sensitive foreign flows with autopiloted domestic inflows has arguably diluted the role of fundamentals in price formation. What we now see is a momentum driven market buoyed by liquidity and overoptimism rather than earnings, capex or productivity gains.

Caveat emptor again!