Three factors to consider while looking at market valuations

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Also read: Rishabh IPO allotment tomorrow - Latest GMP, here's how to check allotment status The earnings growth is a function of multiple factors, e.g., (a) capacity (production capability); (b) demand environment (market leadership); (c) competitive landscape (pricing power, cost advantage); (d) innovation and technology advantage; (e) resource availability (raw material, labor, capital, managerial bandwidth, etc.), etc. The price-earnings ratio (PER), one of the most popular equity valuation criteria, is the ratio between the earnings of a company and its market value. It broadly signifies that at the current rate of earnings how many years it will take for the company to add the value that an investor is paying today.

Principally, an acceptable PER for a company's stock is defined by (a) the return on equity or capital employed (RoE or RoCE) a company is able to generate on a sustainable basis and (b) the growth rate of earnings that could be achieved on a sustainable basis. A company that could generate higher RoE/RoCE consistently and is likely to grow faster, is usually assigned a higher PER as compared to the ones that generate lower RoE/RoCE or have low or highly cyclical earnings growth. Read all market stories here A rise in PER, if not commensurate with the rise in earnings profile needs deeper scrutiny.

Sometimes the rise in PER occurs due to correction in anomalies (undervaluation) of the past. This is a welcome move. Sometimes, PER changes (re-rates) due to relative forces, e.g., a rise of PER in comparable foreign markets or a change in the return profile of alternative assets like bonds, gold, real estate, etc.