The main reason for the market rally is expected profit growth in future. However, the September quarter results do not yet justify this optimism

Over the past year, the S&P BSE Sensex and NSE’s CNX Nifty have rallied by nearly 40% each. In the quarter ended June 2014, the market reacted sharply to the new government at the centre and good results. In the September quarter, the Indian stock market gained steam with improved economic data—falling inflation and improvement in domestic production. Unfortunately, growth in the top-line and bottom-line of companies remained subdued. Hence, most companies are quoting higher valuations.

Out of Moneylife’s sample of 1,294 companies, 1,215 companies have declared their second quarter results. The aggregate sales of the 1,215 companies were just 4% higher during the quarter compared with the September 2013 quarter. During the September quarter, aggregate operating profit of these companies grew 7% year-on-year (y-o-y), while net profit increased by as much as 14%. Over the one-year period ended 21 November 2014, the aggregate market-cap of the 1,215 companies has grown by 45%, while the Sensex has gone up by 39% over the same period.

Therefore, more than the earnings, valuations of the companies have increased significantly over this period. According to the valuation metric of market-cap to operating profit, valuations of selected sample increased by nearly 35% over the year.

This is partly because the market was undervalued last year but the main reason for the rally is expected profit growth in future. However, the September quarter results do not yet justify this optimism.

Profit margins in September quarter remained steady. The net profit margin (aggregate net profit/ aggregate sales) of Moneylife’s sample increased to 7.10% in the September 2014 quarter from 6.46% in the same quarter a year ago. Operating profit margin (OPM) increased marginally to 13.46% from 13.05% over the same period. As many as 600 companies reported an increase in OPM, while 598 companies reported a higher NPM.

Number of companies that reported a net profit in the September 2014 quarter declined to 915 (75% of the sample), from 937 (75% of the sample). As many as 730 (or 60%) companies, reported a growth in operating profit. Also, 729 companies reported a growth in net profit.

The market-cap to operating profit (latest quarter annualised), for the 1,215 companies was 13 as on 21 November 2014, 35.33% higher, compared to an MC/OP of 9.6 as on 29 November 2013.

Another valuation measure considered by Moneylife is market-cap to sales. The MC/sales of the 1,215 companies, was 7 as on 23 November 2014, up 39.56% compared to 5.01 on 30 November 2013. The price-to-earnings (PE) of the sample has increased to 24.6 from 19.4 over the same period. In short, the market sentiment is high and if fundamentals do not improve to support the high valuations in the coming quarters, we may see some correction in prices.