India is expensive – Really?

“A great business at a fair price is superior to a fair business at a great price.” - Charlie Munger

Valuation is one of those topics that’s frequently discussed, yet it never seems to lose relevance. Have you ever wondered why one company in the same sector commands a higher valuation than its peers? Or why one market is valued so differently compared to another?

We often hear about relative valuations, comparing companies within the same sector or against their own historical valuations and drawing quick conclusions. A common assumption is: A stock with lower valuation multiple is cheaper and therefore better. But is it really that simple?

Relative valuation often gets a lot of attention, sometimes without a full understanding of its nuances. While it may not be an exact science, there is certainly a method to madness.

To understand the concept better let’s delve deeper into the science and art of valuation.

Valuation - The Science

At a conceptual level, the valuation of any asset class including equities should reflect the discounted value of its future cash flows. This is relatively straightforward in the case of most asset classes with a pre-determined cash flow (e.g. Bonds, Rented property), but not so easy in the case of Equities.

To arrive at discounted cash flow (DCF), one must estimate a range of future variables such as revenues, profits, free cash flows, growth rates, the longevity and sustainability of that growth, and perhaps most critically, the terminal growth rate. This requires investors to make a series of assumptions, judgements and calls on the known unknown.

So, what are the key variables that drive stock valuations? In our view, the most important ones are:

“Growth + Capital Efficiency + Consistency + Longevity”

Growth accelerates the future cash flow - the higher the growth, the higher the DCF value will be when compared to a similar company in the same sector.

Capital efficiency: after growth, how well a company can generate returns above the cost of capital (discounting rate =risk free rate + risk premium), will determine the valuation. Highly capital efficient companies get far better valuation than lesser ones.

Consistency: we all understand the power of compounding - A company that grows consistently at 15% with steady capital efficiency tends to create significantly more value over time than one with sporadic growth. We tend to assign a higher valuation to a company which grows 15% consistently over 5 years than to one that grows at 18% for 2 years, 10% for the next two and 15% in the final year. 

Longevity and Linearity: the longer a company can sustain its growth & capital efficiency, the higher its DCF valuation will be. What makes it more interesting is the companies with nonlinear growth.  These businesses often have back-ended cash flows, meaning much of their value is realized in the future. As a result, they may appear expensive based on near-term valuation, even though their long-term potential is substantial.

Example:

Let’s take the example of Trent vs Aditya Birla Fashion Retail Ltd (ABFRL) in the above context

Growth & Longevity: Trent has delivered ~22.5% revenue CAGR over 10 years far ahead of ABFRL ~14.8% CAGR

Capital efficiency: Trent delivered ROCE’s of about ~20% again far ahead of ABFRL’s single digit.

Consistency: Trent has delivered double digit growth in 8/10 years along with >20% RoCEs now vs ABFRL’s double digit growth in 2/10 yrs.         .

This has resulted in Trent trading at 11.9x Price/Sales vs ABFRL's ~1.3x, reflecting superior performance and perception.

Valuation – The Art

If the science of valuation is so well understood, then why do valuations vary so widely?

Valuations are inherently forward looking. When it comes to inputs like growth, capital efficiency, consistency, longevity or non-linearity, it is the “expected/ forward-looking view” on these variables. i.e. expected growth, expected capital efficiency, expected consistency, expected longevity / linearity profile. 

Naturally, expectations vary widely from one investor to another. These expectations are shaped by individual judgement, influenced by understanding of opportunity size, competitive advantage, management quality & more.

Judgement is a function of one’s knowledge, experience, personal aptitude, behavioral biases, frame of mind at the time of assessment and similar non quantitative matters.   

Whenever there is a convergence of expectations of a “majority of investors” towards a “common factor”, we often see euphoria or pessimism in the market. For example, no one believed in the potential growth of the manufacturing sector or defense stocks in 2020 and hence most were available at lower valuations. As more and more people developed confidence around the “expected growth” of the sector/companies, their valuations started inching up hitting euphoria. The same was witnessed in 2001 with internet companies and in 2021 with New Age companies. In March 2020, everyone was unsure of growth and stocks tanked, valuations nose-dived. It didn’t matter what the growth eventually would be, but what the expectation of growth was at that time mattered. 

Let’s draw some corollary to the bidding in the IPL. Each season, the auction creates a spectacle where some athletes attract astronomical bids, driven by perceptions of their potential, marketability, or team fit. Others, despite comparable statistics, may go unsold, reflecting the varied judgments of team owners evaluating factors like opportunity, competitive edge, and player reliability."

Why? IPL franchises look beyond current form or performance, prioritizing consistency, pressure performance, adaptability, fitness, and, crucially, the ability to win. Similarly, just as franchises bet on players who can secure titles, investors back companies they believe will deliver long-term, compounding returns—not just in favorable conditions but through diverse and challenging phases."

Investors are willing to pay up for businesses that showcase superior growth, consistency, prudent capital allocation, credible leadership, and the ability to compound value across market cycles over the long term.

Valuation cannot be determined by focusing solely on one factor. Instead, it hinges on the interplay of multiple factors —opportunity size, competitive advantage, management quality, and governance — that collectively shape expected cash flows and discount rates. For instance, some companies exhibit rapid growth but receive lower market valuations due to doubts about their quality or governance. So, despite growth it remains below desired valuation (we will not say undervalued).

Very often we hear people talking about valuations and finding comfort in perceived 'cheapness,' commonly labeled as value. But true value, in our view, lies in buying exceptional businesses at prices below their fair value. Margin of safety should be sought in one’s assumptions about these factors and not just in absolute PE ratios. Hence, we constantly focus on sharpening the quality of our judgement, assumptions and building sensitivity around the probabilities of various outcomes. We can’t predict the future with certainty. We can only create scenarios and assign probabilities to them and that’s where our edge lies. Our edge lies in our differentiated perspective. 

One of the most powerful insights we’ve had in this: When you can identify a change in trend before the majority does, you often find yourself holding a potential re-rating opportunity. This could be a shift in expected growth, an improvement in management quality, or any factor that enhances the core valuation drivers.

We call these “Magic stocks”

For example, we could identify ICICI Bank in 2019, manufacturing and technology in September 2020, PSU banks in 2022, Pharma in 2022 etc.

ICICI Bank in 2019 was trading at less than its book value and hardly had any institutional holding. At that time, investors failed to recognize the change in “expected growth” under the leadership of Sandeep Bakshi which led to a significant re-rating eventually as more people got convinced about expected growth of future.

Similarly, there was a lot of disbelief in manufacturing in India in 2020 leading to many of the manufacturing stocks trade at low double-digit multiples. Investors ignored the series of reforms in India and global rebalancing from China which in our view could re-rate the entire manufacturing sector. Our shift strategy launched in 2020 was specifically designed to invest in manufacturing & technology, where, based on our estimate, expected growth was accelerating. Over the last 5 years we have witnessed a significant re-rating of manufacturing stocks with many of them becoming 5-10x driven by a combination of valuation re-rating and earnings growth.

Similarly, whenever the majority find comfort in the expected value of these variables in any company/sector (which means they are obviously trading higher valuations) and if one can identify deterioration in the expected value of these variables, (negative rate of change) ahead of everyone else, you can avoid a potential loss. e.g. we avoided most owned stocks like Asian paints, HDFC Bank, Bajaj Fin not because they were bad companies, but we could see the deterioration in expected values of some of the factors.

Ultimately, what creates euphoria or pessimism is nothing but subjectivity and judgement around future value of these variables.

Now let us extend the above logic when comparing valuation multiples across countries

This brings us to a common question we hear from investors:“Why is India the most expensive market among emerging economies?” The most frequent comparison is with China.

However, if one considers India as a company and deep dives into factors which determines valuation - “Growth + Capital Efficiency + Consistency + Longevity” one would get an answer to this question.

Why should India command a valuation premium to other markets?

There is no country which comes even closer which offers a combination of all the factors pointing in the same direction; it is the combination of all these factors which determine the premium valuation.

This is the very reason that since 2002, China despite having a high GDP growth has delivered ~4.1% CAGR vs ~12.0% CAGR for India. ($ based Index returns; for China – Shanghai composite, for India – Nifty)

Microscopic view of India vs other countries

Indian equities continue to command a premium over both developed and emerging markets, with the Nifty trading at 21.9x FY26E earnings as of May 30, 2025—well ahead of China, Korea, Brazil, and Europe. This premium is underpinned by India’s structural strengths: robust GDP “growth” (6.5–7% expected in FY26–27), superior “capital efficiency” (leading ROEs) macro stability, moderate debt levels (~83% of GDP, mostly domestic), and strong forex reserves.

On “longevity”, India’s demographic dividend, rapid digital adoption, and reform momentum (GST, IBC, PLI) further strengthen its long-term outlook. India expects to deliver world leading growth during the Amritkaal period regaining its share in the global GDP from ~3% to ~16%.

In a world grappling with demographic aging, high debt, and policy uncertainty, India stands out as a rare long-term growth, leadership and governance story, justifying higher multiples. We would be really surprised if India traded cheaper despite such factors.

India’s valuation premium reflects more than short-term optimism—it is a function of sustained growth, quality earnings, capital discipline, and a structurally improving macro environment.

Why should India command more valuations than its historical average:

If one looks at all the input variables of valuation, India offers a far more sustainable and stable growth thereby reducing the risk premium compared to its historic times. Most structural fault lines of the economy (CAD, fiscal, banking system, inflation and leverage) are well in control and best at any given time in history. Also, the risk-free rate is the lowest in history, especially when measured in comparison to the difference in 10-year G-sec between India and US, at ~180bps.

You might find it astonishing to note, a simple 2% reduction in the discounting rate, with everything else remaining the same, improves the DCF value by ~32-36%. Still expecting and comparing India to the historical valuation range is not the right thing to do.

Our view and conviction is that India will get further re-rated in the years to come as more players, especially global investors gain confidence on the expected value of input variables of the Indian economy.  Both global & domestic investors are still underweight India viz its potential.

Valuation, in our view, is not just about numbers—it’s about conviction in outcomes. As long-term investors, we focus on businesses that deliver more value per rupee invested. We believe India will remain best market for a very long time. We are lucky to be part of this wealth creation cycle. So are you!