For sustained economic growth, it is essential to have a stock market

that mobilises and allocates capital efficiently. To place the capital

market in perspective, it would be useful to distinguish between the
new issues market and stock exchange.
The new issues market allocates long-term funds to corporates in an
economy without constraining the investment horizon of the investors.
The stock exchange facilitates buyers and sellers to transact in
securities issued in the new issues market.
Hence, the economic significance of the stock market stems from its
role as an allocator of resources. As a result, the new issues market
which is of primary importance to the economy is called the primary
market and the stock exchange which provides liquidity and
facilitates price discovery is called the secondary market.
A vibrant secondary market must ensure an efficient primary market.
However, in the case of India, though the economy is home to the third
and the fifth largest exchanges in the world in terms of the number of
transactions, the amount of capital mobilised in the primary market is
negligible.
To substantiate this claim, it may be noted that between 1996 and 2006
debt instruments accounted for more than 80% of the funds raised from
the primary market. Dependence on debt per se is not bad, however,
what makes the situation grim is the fact that more than 80% of the debt
was issued in the form of private placement.
In terms of mobilising funds from the capital surplus economic units,
the primary market attracts less than 4% of the total savings of the
household sector. Therefore, it can be said that the basic economic
function of the primary market, which is to act as conduit between the
sources and uses of new capital funds in an economy, is not being
adequately addressed by the Indian markets.
Hence, a well developed secondary market has not been able to provide
the corporate sector with permanent access to capital by making
investments less risky to investors. In a survey of Indian investors,
conducted by Sebi and NCAER in 2001, it was seen that less than 4%
of the total households invest in equity market and most of these are
urban households.
Further, the survey revealed that about 80% of the households were first
generation investors and a majority of them held inadequately
diversified portfolios. The main reasons for not investing in equity

share market were: low per capita income; apprehension of loss of

capital; and economic insecurity. At least two of these issues can be
directly addressed through proper valuation.
Presently, initial public offers in India are evaluated by following the
price to earnings (P/E) multiple approach. The approach is followed
irrespective of the sector to which the firm belongs. However, it has
been established in prior research that the use of multiples varies across
sectors, viz., the enterprise value/earnings before interest taxes
depreciation and amortisation (EV/EBITDA) multiple is a better
approach to evaluate infrastructure business and price to book value
(P/BV) multiple is a better approach in the financial services sector.
Every multiple, whether it is earnings, revenues or book value is
representative of the same three features i.e., risk, growth and the cash
flow generating potential of the firm.
In case of P/E, the key determinants are the expected growth rate in
earnings per share, the cost of equity and the payout ratio. However, at
a firm level, prior empirical efforts have found only weak relation
between P/E and factors stated above.
At a theoretical level, as any other ratio based on accounting measures,
the P/E also suffers from an inherent lag. The numerator is flow
variable which evolves with time while the denominator is a stock
variable. Hence, such a ratio may not represent the true risk of a firm at
a point in time.
Also, within the same year the P/E at different points in time is
different. Hence, the value of the company may differ a lot depending
on the P/E used. An analysis of the P/E, for 2006-07 of the firms
included S&P CNX nifty indicates that in the case of more than 60% of
the firms (33 firms) the high P/E was 1.5 times the low P/E.
And in the case of a third of these 33 firms, the high P/E was at least
twice that of the low P/E. Thus, P/E multiple based valuation can at best
be treated as an approximation that must be cross checked with the
more scientific discounted cash flow method.
Again, while using the P/E multiple, a stable range in which the ratio
oscillates needs to be identified and a weighted average of the ratios in
that range should be used in order to make it representative of steady
state future growth potential.
(The author is a Faculty in the finance area at the Indian Institute of
Management Kozhikode)