Equity valuations remain elevated across metrics, such as trailing and forward price-to-earnings (P/E) ratios, market capitalisation-to-GDP and earnings yield despite the recent correction, said the Financial Stability Report released by RBI on Monday.

Stretched valuations are more prominent in midcap and smallcap stocks. Notably, the Nifty Midcap 150 index was trading at P/E ratios close to 43.7 in mid-December compared to its long-term average of 34.8. Moreover, despite a sharp increase in the benchmark P/E ratio from 34 in March to 42 in November, about 56 per cent of stocks in the Nifty Midcap 150 Index were trading higher than the benchmark P/E.

Similarly, 64 per cent of both smallcap and microcap scrips traded with a P/E ratio above their respective benchmark P/E ratios.

To justify the current valuations for all indices, the required earnings growth should exceed the expected earnings growth to forestall a large and abrupt market correction, said the report.

The big picture

However, corporate earning in the September quarter indicate a slowdown as reflected in earnings per share (EPS) estimates. Another emerging area of concern relates to IPOs of small and medium enterprises, it said. There has been a sharp increase in demand for SME IPOs, with several IPOs oversubscribed 100 times or more on account of rising participation from retail investors.

In many cases, there appears to be no direct correlation between company fundamentals and the sharp rise in stock prices of SMEs. The SEBI has observed that some SME companies and/ or their promoters engaged in practices that present an overly optimistic or unrealistic view of their

operations following their listing on exchanges, which are often followed by corporate actions, such as bonus issues, stock splits, preferential allotments and similar measures, to influence stock prices.

Accordingly, the SEBI has issued orders against certain entities engaging in such activities and also issued advisory urging investors to remain vigilant and cautious when considering investments in SME securities, said the report.

Foreign portfolio investors sold equities worth $11.2 billion in October, marking the highest recorded FPI monthly outflow. In contrast, domestic investors (institutional investors, mutual funds and individuals combined) remained net buyers of equities for the eleventh consecutive month and in 15 of the last 16 months.