Indian corporates are expected to announce good financial results for the quarter ended December 2009. Earnings growth rates have accelerated during 2009. They grew by 15% in the quarter ended March 2009 and then rose to 19.9% and 38.3% in the June and September 2009 quarters. CMIE expects an even higher growth of 41% in the last quarter of 2009.

There are at least three reasons why the December 2009 quarter results will look very impressive. First, the y-o-y growth rate will benefit from the 29% fall recorded in the base quarter. Secondly, companies have benefited by not passing on the cut in excise duties announced by the government last year, and commodity prices and interest rates have fallen. Thirdly, and perhaps most importantly, it is apparent that there is a smart recovery under way. Optimism has returned on the back of robust domestic demand.

The expected increase in earnings may buoy the stock markets. The price-to-earnings ratio of CMIE Overall Share Price Index (COSPI) companies was 23.5 around the middle of January 2010. The COSPI includes over 2,000 companies. It is, therefore, the most comprehensive measure of the performance of listed companies.

The Nifty P/E was also around the same level while the Sensex P/E was lower at around 22.6. At least in recent times, the P/E of the Sensex30 portfolio of companies has been systematically lower than that of the Nifty50 portfolio; and the COSPI has been somewhat higher. Part of the reason why the COSPI companies have a higher P/E is that these include the petroleum PSUs like IOC, HPCL and BPCL that are absent from the Sensex and the Nifty. Also, on an aggregate basis the inclusion of several smaller companies raises the P/E of the portfolio.

But, these differences apart, generally, the P/E is currently around 22-23. And what is important is what would happen to it once companies announce the expected good financials by around the end of this month. If the results are as good as CMIE?s projections, then we should expect the P/E to fall substantially. When the results of the previous quarter were out, the P/E fell quite sharply. Earnings were up by over 38%, as a result the P/E of the Nifty50 fell from 23 on October 17 to below 20 on November 3, 2009.

Other indices took a similar dive. But what is interesting is that by the middle of January, they were all back to their levels as of the middle of October.

The markets seem to be saying that a P/E of 22-23 is what they believe and if the P/E falls as a result of good financials this quarter, it will pretty much bounce back to the levels of 22-23 soon. If this is true, it implies that the markets should rise in February and March. I do not intend to predict market trends. The idea is to understand the way markets seem to value stocks.

A P/E of 22-23 is generally considered high while a P/E of around 12-15 is usually considered to be reflecting a fair-valued market.

However, the P/E of Indian listed companies as a whole has rarely been lower than 15, at least since late 2005. It was below 15 only during the period of the global liquidity crisis?September 2008 through April 2009. By June the ratio had touched 20 and has inched up further since then. It shrugged off the crisis pretty quickly. This probably reflects the market?s confidence in the corporate sector and its confidence in a P/E of around 22-23.

The average P/E in the past four years has been persistently high. This is particularly true of the COSPI portfolio where the P/E averaged 21.6, 25.1, 22.9 and 21.9 in 2006, 2007, 2008 and 2009. The corresponding numbers for the Sensex30 were 20.2, 22.3, 18.2 and 18.1. The average P/E in the preceding four years?from 2002 through 2005?was much lower, in the range of 12-17.

The rising P/E reflects the greater confidence reposed by investors in the capacity of Indian companies to grow their earnings aggressively. Now, what if the investors take the P/E to 25, or even beyond? Should we say that the markets are overpriced? And if so, why?

If Indian companies have fundamentally strong balance sheets (as they do have around now) and if they continue to grow aggressively through investments (as they also seem to be doing around now), there is good reason to repose faith in a market that may value them higher.

In the current circumstances it would be wrong to target an increase in asset values as a bubble. What is important is that companies are subjected to the strictest accounting standards and are required to make copious disclosures to the markets. Exceptions such as the one made by the government last year for AS-11 and such as on the one by Sebi that permits companies to delay disclosing the financial results of the last quarter of a company?s accounting year should not be allowed. But a gradual rise of the P/E to higher levels during times of growth should not be frowned upon by the regulators. Let that privilege rest with the investors.

The author heads Centre for Monitoring Indian Economy