The media bulls are back, with a vengeance. After having called the market wrong twice in the last 12 months (markets went on to correct by over 10 per cent even as the media remained excessively bullish), they now seem to be betting they will be third time lucky.

And this time it is no easy target. Now it is Sensex 7,500 by end of 2005. Our advice to you -- while we hope they are right (!), you should avoid the temptation to jump headlong into equities.

There is no denying the India story. And there is no denying the fact that valuations today are not outlandish (more on this later). But, nonetheless, investing in equity just because foreign institutional investors will buy (a very popular reason) in a big way may not be the best move.

Most FIIs currently operating in India do not have long-term funds at their disposal. Anything from a rise in interest rates in the United States to political unrest in the Gulf/Asian sub-continent could trigger a sharp pullback.

And, more importantly, equities as an asset class are best suited for investment horizons of more than three years. Buying into equity from a 6-9 month horizon in our view could spell disaster.

Another point which is very relevant here is that no matter how attractive an opportunity, you have to maintain a diversified portfolio of assets, comprising among others property, gold, stocks and deposits.

This portfolio is geared to meet a certain need. Changing its allocation radically to capitalise on a short-term opportunity can jeopardise the accomplishment of the objective. So, beware of anyone who is pushing you on to this perilous path.

Now coming to the valuations, which seems to be a strong reason to buy Sensex. Here we lay out our simple argument for why valuations may not be excessive (without the jargon).

A share price of a company is determined by several factors. Since here the reference is to valuation, we will focus on just one method of determining the stock price, which is:

Stock Price = Earnings per share (EPS) * Valuation multiple (also called the Price to earnings or P/e multiple)

Alternatively, to calculate the value of the entire company (market capitalisation), and not just one share --

Market Capitalisation = Net Profit * P/E multiple

The tricky part here is that while the net profit (or earnings per share) is known (or there is not significant variation in expectations), the P/E multiple to a stock is assigned by the market. This multiple depends on many factors including:

• a. Sentiment in the stock market (the impact of FIIs falls into this category),

• b. Prospects of earnings growth going forward.

'Point b' basically means that the valuation multiple of the company is usually in line with the sustainable rate of earnings growth. So, if one expects earnings to grow 10 per cent per annum in the foreseeable future, the P/E multiple assigned to the stock should be about 10 times.

So if the EPS of the company is 5, the price will be Rs 50 (Rs 5 * 10; 10 being the P/E multiple). Or in case the net profit is Rs 10 million, the market value of the company will be Rs 100 million (Rs 10 million * 10).

Ultimately the Sensex comprises a select list of thirty companies which have their shares listed on the stock exchanges.

So in a way, the Sensex is like a diversified company having many units, with each company representing one unit. In the case of the Sensex, the number of units is 30. The profit which the Sensex earns, therefore, is the total of the profits of all these units.

This profit number is a given, but there will be some difference in expectations going forward.

The growth in the Sensex will therefore come either from a growth in profits (or EPS), a rise in the P/E multiple, or both. Let's lay it out in numbers.

Assume current Sensex is 90 with an expected EPS of Rs 6 (year ending March 2006) implying a P/E multiple of 15 x.

Sensex = EPS * P/e
= 6 * 15
= 90

It is expected that the EPS of Sensex companies will grow at about 20 per cent p.a. in the foreseeable future. This has two implications, i.e. one the EPS number will rise and so will, possibly, the P/E multiple.

So, looking another year ahead (earnings for financial year ending March 2007), one can expect the Sensex to be--

Sensex = 7.2 (EPS) * 20 (P/E) = 144. This implies an appreciation in the Sensex of 60% from current levels. Although this may seem very simple, you still need to be cautious. The reasons for this are:

• The implicit assumption is that the EPS number for the Sensex will be met.

• Again, the assumption is that two years from now, the markets will continue to expect growth of 20% pa. That number could reduce to say 10%, thus resulting in 20% erosion in the Sensex value.

• The Sensex comprises just 30 stocks while the markets consist of over 2,000 actively traded stocks. Therefore the Sensex may not necessarily be representative of the broader market. A case in point being that stocks of smaller companies in recent years have outperformed the Sensex by a wide margin.
  

• Most importantly, markets do not move in one direction only. There will be volatility and there could be losses for significant periods of time. It is very possible that in a three-year investment that you made, all the returns could have come in the last 3 months of the holding period. So, you need to be patient and at the same aware of the happenings in the companies you are invested in.

A more rational (or conservative) expectation will be that while the EPS for the Sensex will rise by about 20 per cent, valuations may not necessarily move in sync (as it is difficult to predict interest level of FIIs etc).

So instead of the 60 per cent jump in the Sensex, one can expect an appreciation of just 20 per cent, in line with the growth in EPS. And that is approximately how the 7,500 number is arrived at.

Our advice to you

1. Irrespective of the apparent attractiveness of the stock markets, invest only in line with your overall asset allocation plan. Visit Personalfn's Asset Allocator.
   

2. Stock prices track a company's performance. So, invest in well-managed companies that are on course to deliver the goods. Else, when the froth in the markets settles down, you could be sitting on significant losses (remember the tech meltdown?).
   

3. If you are not actively able to track the stocks you are invested in, opt for mutual funds.

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