How cheap/expensive are the Indian markets now

To invest in Equities given the market performance till now and how it is expected to perform is a key question in the allocation to equities. One of the simplest tools to measure how expensive or undervalued the equity markets at a broad level is Equity Risk Premium. Study of this number typically has loads of tales to tell. They depict the risk investing in the market as a whole given the past performance and the expected performance given the earnings that is expected.

This is an attempt to study the implied risk premium prevailing in the Indian market and the returns that can be expected from the Indian markets. There are three components that determine the Equity Risk Premium. A study of all these three variables would have useful insights that would help in fine tuning the investment strategy.

The Expected Returns (Er) that is derived from the expected earnings from the market. This is a good indicator of what is the rate at which the market is discounting the future earning of the companies. Expected returns from the average estimates earnings estimates is close to 12.68% as on 5^th July 2013 as against 12.25% in 31^st March 2012. Even though the index has increased from 5,295 to 5,867 in this period, the risk premium has increased marginally signifying the expectations of volatile times in days ahead.

The Indian bond yield has reduced from 8.5% to 7.5% in this period. Using the government bond as the risk free rate, the Equity risk premium derived for the Indian equity markets is 5.11% as against 3.75% March 2012.

The risk premium seems to have gone up from the levels seems in the last year in spite of the index being at a higher level. This is indicative of the stress that the markets are expecting in the near future and this is getting factored in the discounting rate. To enter or not this market at these risk premium would call for an analysis of historical trends in risk premium and at a individual level, how optimistic or pessimistic one feels about these risk spanning out.

One of the key trends found in this analysis was that risk impacted mid/small caps differently than from large caps. Hope to write on that in the next post...