By SHEFALI ANAND
Indian stocks are not expensive and have not been for two decades, says a top American economist.
For years, money managers have described Indian stocks as expensive because of their high price-to-earnings ratio, which compares the price of a stock with the company's net profit per share. For instance, the Bombay Stock Exchange's Sensitive Index or Sensex recently closed at a price-to-earnings ratio of 19, much higher than the price-to-earnings ratio of the MSCI Emerging Markets Index at 14.
India has always had a higher ratio.
But research from one of America's pre-eminent financial economists shows that these ratios don't tell the whole story, and can underestimate the worth of Indian stocks.
Instead, Rajnish Mehra , a professor of finance at the University of California in Santa Barbara, focuses on India's economic growth to value Indian stocks. When compared to India's gross domestic product (excluding agriculture), Prof. Mehra finds that stocks were cheap or fairly priced between 1991 and 2008.
Prof. Mehra, 60 years old, is renowned for his ground-breaking research on the large difference between returns from stocks and bonds. In a paper published in 1985, titled "The Equity Premium: A Puzzle," Prof. Mehra and co-author Edward Prescott for the first time revealed that between 1889 and 1978 stocks in the U.S. produced a far greater return than risk-free government bonds than was suggested by conventional economic theory at the time.
The seminal paper has spurred dozens of economists over the past two decades to try to solve this puzzle.
In his most recent paper, available on the website of the National Bureau of Economic Research, Mr. Mehra attempts to find a fair value for Indian stocks. M. Mehra grew up in India but has lived in the U.S. for more than three decades.
He looks at three main factors to derive the fundamental or intrinsic value of Indian stocks—corporate capital stock, i.e., total assets of companies, after-tax cash flows of companies, and net corporate debt.
The cash flows help Mr. Mehra estimate "intangible capital," which he says has contributed vastly to increasing the value of Indian companies over the past two decades.
Intangible capital is essentially everything that contributes to the company's bottom line but typically can't be seen or touched. This includes things like a company's brand, research and development, and scientific knowledge.
For instance, consider soft drink-maker Coca-Cola Co. Its product is basically just water and sugar plus that special formula, but the value and profits of the company are derived from the Coca Cola brand. This brand value is Coca Cola's intangible capital.
Accounting for intangible capital in valuing stocks is an "innovation of the study," says Prof. Mehra.
Some money managers agree.
"What price-to-earnings [ratios] can't take into account is any structural change," says Surjit Bhalla, managing director of Oxus Investments Pvt. Ltd., a Delhi-based economic research and asset-management firm. As the Indian economy changes rapidly, industries are expanding, workers' skills are broadening, and infrastructure is improving. All these changes impact the productivity and ultimately profitability of a company significantly without ever showing up in its profit and loss statement.
In such a scenario, "this static tool of price-to-earnings is not that applicable," says Mr. Bhalla. He says it might be more useful for developed countries, where there's very little structural change.
Mr. Mehra uses three different methods to determine the intangible capital for Indian companies, including one in which he adds up direct investments in research, technical knowledge and royalties. In cases where specific data were not available, he made estimates based on U.S. data.
He found that between 1991 and 2004, Indian stocks were cheap compared to economic growth. After 2005, investments "went up exponentially," making stocks fairly priced between then and 2008, says Mr. Mehra. At one point in 2008, Indian markets became expensive as stock market values outpaced economic growth, but it came back down again. Mr. Mehra cautions that the study doesn't account for foreign institutional investment in India, though ultimately, he says it shouldn't matter whether the investments are made by domestic or foreign players.
While Mr. Mehra's study concludes in 2008, he estimates that Indian stocks are about fairly valued now.
What does all this mean for investors?
Mr. Mehra expects Indian companies' intangible capital and the economy to keep growing rapidly for many years. That, in turn, will help Indian stocks to rise, making them a good investment especially for young people saving for retirement. "Buying stocks is buying the productive capacity of the world," says Mr. Mehra.
Mr. Mehra cautions that his research doesn't account for short-term movements in the stock market, so he can't predict where stocks will be over the next year or two.
Personally, Mr. Mehra doesn't typically buy individual stocks because that's a risky strategy. Instead, he buys a large number of stocks, through exchange-traded funds or index funds, which aim to provide the return equivalent to a specific index like the Sensex.
Mr. Mehra also emphasizes the need for diversification. This means that individuals should buy not only a number of different stocks but also stocks in different parts of the world, as well as other types of investments like bonds, real estate and commodities.
"You diversify across assets and political jurisdictions," he says.
Write to Shefali Anand at shefali.anand@wsj.com
From The Wall Street Journal published on JULY 30, 2010, 7:16 A.M. ET