On Tuesday, India’s stock market value hit the $4-trillion mark for the first time, positioning the world’s fifth-biggest equity market as one of the best performers in the region and the global emerging markets.

The market capitalization—the total value of all a company’s shares of stock—of BSE-listed firms collectively soared nearly $30 billion to reach this milestone and has jumped by $1 trillion all in just 3 years.

However, all that glitters is not gold on D-Street.

On Monday, Kotak Institutional Equity Research raised a red flag on the market valuation. In a note, the firm highlighted several “flaws” in the current valuation practices within the stock market. These flaws have inflated the “fair” values of stocks while downplaying the potential risks attached to the companies’ business models, according to the note.

“We note two broad problem areas: (1) the disconnect between valuation approaches and business models and (2) the inordinate focus on near-term earnings. These practices have persisted for a long time, resulting in a mistaken orthodoxy about valuations,” the note said.

This note of caution comes just months after the firm stopped its recommendations for the mid-cap portfolio as it found few stocks—except those in the financial sector—that have further upside potential amid the Nifty mid-cap index’s record rally. The rally had left most of the 15 stocks in the brokerage’s model mid-cap portfolio trading near their 12-month fair values. We also wrote recently about the irrational exuberance in mid/small-cap stocks and the risks it poses for relatively uninformed investors. (Also read: Why are mid/small-cap stocks defying gravity?)

Let’s take a look at what the note said:

The discrepancies: First, there is the blind application of multiples to inflated bottomlines—a company’s income after all expenses have been deducted from revenue. A “multiple” measures a company’s growth, productivity and efficiency by dividing two metrics. The brokerage firm warned in the note that the market’s current valuation approach relies heavily on the “historical” price-to-earnings or EV/EBITDA multiples. (EV stands for enterprise value and EBITDA is earnings before interest, taxes, depreciation and amortization.)

The firm said this approach may be “too simplistic” as it overlooks potential shifts in business models and sector environments. For example, in the case of sectors like automobiles, electric utilities, and oil and gas, this valuation approach might not consider the possibility that these businesses could lose a lot of their value in the long run. This is because these industries are at risk as the world moves away from fossil fuels to greener alternatives.

“In our view, it seems imprudent to use the multiples relevant for a certain operating environment to an entirely different environment,” the firm said.

Additionally, the firm also noted that the current practice of using a composite multiple to evaluate the earnings of stocks regardless of where the earnings come from is “quite incorrect”, as this method overlooks important details about each business.

Second, there is a heightened emphasis on near-term earnings instead of long-term growth prospects. The firm finds the practice of according multiples to “limited-opportunity” or “limited-period” earnings to be “quite absurd as it vastly overstates the value of such earnings streams. By definition, ‘limited-opportunity’ or ’limited-period’ earnings are non- recurring in nature and it makes little sense to treat them otherwise”.

Third, the stock market uses high multiples to value businesses with high growth but heavy capital expenditures, like those in construction materials and specialty chemicals. The brokerage firm calls this approach “rather careless”. While the market pays attention to the rapid growth in earnings, it tends to overlook the high capex that is required to sustain this growth, resulting in low/absent free cash flow.

On top of this, the brokerage firm noted that the risks to valuation estimates, disruption threats and the effect of persistently high interest rates are being overlooked by the market.

Now, how did the stock market get to this point where traditionally bullish brokerages have to be the harbingers of caution?

Background: To understand the surge in valuation, let’s break it down into three factors that mostly drive the boost: Sentiment, liquidity and fundamentals.

In terms of sentiment, the driving forces are election results, the US federal Reserve’s stance and easing inflation in the country. The Narendra Modi-led Bharatiya Janata Party recently won in the three of the five state elections—the last set to be held before the 2024 Lok Sabha polls. “Post-state elections, market optimism thrives, confirming policy continuity and meeting investor expectations,” Vinod Nair, head of research at Geojit Financial Services, told Deccan Herald.

On top of this, driving the momentum is the anticipation of upcoming policy meetings of central banks—the US Fed and the Reserve Bank of India. Both are expected to keep interest rates steady as inflation is easing, according to Mint. The two central banks aim for a lasting decrease in inflation—the RBI’s target is 4%, while the US Fed’s is 2%. Economists expect the Indian central bank to consider reducing interest rates only in the second half of the next fiscal year, depending on the American central bank’s stance, according to Mint.

Coming to the boost in liquidity, which can be credited to the return of foreign institutional investors to the Indian stock market, a shift in allocations for FIIs from China to India, and a rise in mutual fund inflows. Just within the first six days of this month, FIIs have bought Indian shares worth over Rs 8,800 crore in the cash segment.

“The aura of the state election results and other positive factors like above-expected earnings and GDP growth data are supporting the return of FII flows to the Indian market,” The Times of India quoted Nair as saying.

“The big trend we have seen so far this year across the Asia-Pacific region is that people have been consistently selling exposure in China and buying Japan and India. In India’s case, the flows have been very strong for the last three months,” Sunil Koul, APAC equity strategist at Goldman Sachs, told The Economic Times.

Additionally, according to the latest available data, equity mutual fund inflows surged to Rs 19,932 crore in October while systematic investment plans (SIP) inflows touched an all-time high of Rs 16,927.86 crore

In terms of fundamentals, the surge in market valuation rests on robust performance by companies in the second quarter of the ongoing fiscal. “The consolidated earnings of the S&P BSE 500 index constituents were up by 25 per cent y-o-y in Q2FY24, led by margins tailwinds, while topline growth remained soft at 5 per cent y-o-y over the same period,” Anand Shah, head, PMS & AIF investments, ICICI Prudential AMC, told The Hindu BusinessLine.

In addition to this, in the absence of private capex growth, government capex is sustaining momentum especially with the compulsions of multiple elections. This is driving momentum in infrastructure and subsequently benefiting sectors like cement and steel. We had written about the finance minister insisting that private capex is picking up, but official data showing otherwise.

The Indian real estate sector is also witnessing a revival and this is translating into increased demand for related industries like cement, steel and paints.

Cause for concern: As Kotak highlights, historical multiples are being applied to a changed scenario—basically, these multiples are being applied to a bottomline bloated by a favourable inflation cycle. Essentially, companies are earning more because of lower input costs—October was the seventh consecutive month that India’s wholesale inflation has stayed in the deflationary zone—but this may not be a lasting situation.

Even in the case of the S&P BSE 500 companies mentioned above, sales have only grown 5% year-on-year, indicating the unsustainability of this trend unless demand improves. Moreover, even this growth is skewed, with oil marketing companies, auto, infrastructure and banks leading with high growth, while IT, agriculture and consumption sectors are lagging.

During market highs, brokerages are generally quick to justify it with the belief “this time it’s different” but this where Kotak’s note assumes significance. It has not only pointed out risks in the mid/small-cap segment, but has also clearly called out valuations going off the rails. However, despite these cautionary notes, the rose-coloured glasses of optimism are still firmly in place.

With inputs from Ujval Nanavati