The Nifty 50 index’s key financial metrics, such as return on equity (RoE) and debt-to-equity ratio, are set for a boost following key changes in its components.
From April 1, the NSE has decided to drop stocks including Cairn India, Vedanta and Punjab National Bank (PNB) from its premier index to be replaced by Aurobindo Pharma, Bharti Infratel, Eicher Motors and Tata Motors DVR.
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According to an analysis done by ICICI Securities, the changes will improve Nifty’s RoE by 80-90 basis points (bps) and reduce its leverage. The 50-share index will also see some improvement in its earnings, which could boost its valuations. The brokerage said the new components will “improve the quality of fundamentals of the overall index”.
“The low leverage of incoming stocks relative to the high leverage of outgoing stocks will further improve Nifty fundamentals. Higher leverage of Vedanta and PNB would have resulted in recapitalisation requirements and earnings dilution,” said a note by ICICI Securities, which has set a 2016 target of 8,270 for the Nifty, implying a 10 per cent upside from current levels.
The changes will result in improvement in free-float earnings of Nifty by 100 bps in FY17 and 60 bps in FY18.
ICICI Securities said the structure of the index is shifting in favour of high-quality sectors such as pharmaceuticals, automobiles, information technology and private banks, which could justify slightly higher valuations.
“Pharma, auto, IT, and private banks collectively constitute about 55 per cent weight in the Nifty which is an increase of 87 per cent over the past six years… the overall Nifty RoE has been drifting lower from 19.4 per cent in 2009 to 14.7 per cent in 2016 primarily because of the sharp drop in profitability of the remaining 45 per cent weight comprising primarily of industrials, commodities and public sector banks as well as a dip in the profitability of the relatively,” said the note.
“We believe that as the composition of the Nifty shifts towards relatively higher ROE and sustainable earning stocks, it should trade at a premium valuation to its historical average,” it added.
At 8,270, the Nifty will be valued at 15.9 times its one-year forward price-to-earnings multiple.