I have written on this topic is due to current market fall and fear into the mind of an investor. We are seeing many uncertainties hindering the growth of the economy, rising crude oil prices, commodity prices, fiscal deficit, banks NPA, government expenditure, rising interest rate, the success of GST, structural changes into the economy. All such events will impact the growth of business positively or negatively. If we try to put all such events into different scenarios then we can come to know what can be a probable return from SENSEX in coming 10 years.
For the calculation of probable return, I have taken a formula which is given by John P. Hussman. John P. Hussman is the U.S.A stock market analyst and owner of the hedge fund.
Formula –
Annualized Return (%) = (1+g)(future PE or P/BV / current PE or P/BV)^(1/T) – 1 + dividend yield (current PE or P/BV / future PE or P/BV + 1) / 2 |
G = Business earning growth, P/E = Price to Earnings ratio, P/BV = Price to Book Value ratio
Return of our investment is based on –
Business Earning Growth – Our investment return will grow if particular business earning will grow. Investment return is directly related with the earning of a business. If business survives for the longer period of time with generating the higher return on invested capital with earnings growth then we will able to earn a decent return from particular business.
Dividends – Dividends comes from the earning of the company. If a company distributes dividends to shareholders with growing earnings, the dividend is an additional return for the shareholders with the appreciation of business value. As per Mr.Buffett, if the company does not have a reinvesting opportunity available or business does not able to generate a higher return than the cost of capital then management should distribute earnings in form of dividends.
Changes in the valuation – the Stock price of the particular business is also affected by the changes in the valuation such as changes into the P/E, P/BV, P/S (Price to Sales) or Market Cap to Sales, etc.
Assumptions –
- Dividend yield (%) is assumed to be 0.50% to 1.00%.
- Business Earning Growth (%) is assumed 3.50% (a rate, which is half of the current GDP growth), 7% (current GDP growth rate) and 14% (twice of current GDP growth rate). Assuming average earnings growth of various businesses comprises SENSEX.
- Future P/E taken as 19x (Historical average of last 20 years since the year 1998), 21x (10% premium on historical average P/E) and 23x (20% premium on historical average P/E).
- Future P/BV taken as 3.29x (Historical average of last 20 years since the year 1998), 3.62x (10% premium on historical average P/BV) and 3.95x (20% premium on historical average P/BV).
We can use a similar kind of valuation matrix for the particular business itself. Here, I have also shown valuation calculation of an air cooler manufacturing company of India, I have calculated as I was at the year 2012 and what can be a probable return from particular business till the year 2022.
If we consider actual business performance then sales of the company have been grown by 17% CAGR since the year 2012 to the year 2018. But the stock price has been increased to Rs.2209 (high price and the current price is Rs.967) from Rs.130. This entire return is come to the stock only because of valuation multiple expansion such as P/E, P/BV, EV/EBITDA etc. Similar period has P/E increased to 85x (high P/E and current P/E is 46x) from 23.63x and P/BV increased to 33x (high P/BV and current P/BV is 11x) from 5.84x.
Disclosure – I am not using this valuation matrix in my investment journey till now. This is only one of the valuation matrix and we need to use a different appropriate valuation matrix for reaching to a value range.
Learn matrix from –