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India: The Rising Elephant

The bursting of the stock market bubble

By Shruthi Jayaram
Oct19, 2008
I watched an interesting newsclip on NDTV Profit's Big Business show today. An economist from one of India's largest companies argued that the precarious dipping of the Sensex below 10,000 on Friday is a desirable repricing of equity towards a more realistic estimate of company's earnings. Granted that the rate of growth of earnings have in no way matched the rate of growth of equity prices over the last two years, this assertion nonetheless surprised me. I understood the dipping of the Sensex to reflect a) investor sentiment on future earnings of firms b) effect of a drop in demand and rise in supply from FII investors, a sizeable proportion of stock market participants. Both of these have resulted in a repricing of stocks, and I believed that this was negative, rather than positive for the company.
In effect, I think this point calls in this question - what does the price of secondary trading on its equity imply for the company itself?
Oct19, 2008
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2 Comments

Varun Khandelwal

Oct 19, 2008 at 3:08am

Shruti.. I agree with the points you made. The NDTV economist probably doesnt live on a place we call Earth. Falling stock prices are disastrous for individual companies and the economy at large.


For the economy, its the usual wealth effect negatively affecting consumer behavior, contraction of investment owing to lower financing, busting of pension funds/longer term savings (interesting to note that an investor in the US/European markets since 1998 has made no gains whatsoever except for dividends..probably a below 10% return in 10 years). I somehow don't understand how the economist thought that was good.

As for individual companies, lets see. 

A rapid change in a company's stock price in these times affects its credit ratings..When institutions loan money to a company, they look at what the company is worth just the way they look at what people are worth before issuing them a loan. 

A lot of corporate plans/fund raising are based on assumptions of market capitalisation. 
When your market capitalisation reduces by 50-90% in a matter of months (I'm talking blue chips), its hardly a good things for the company. Even more radical, buy  is the case when the market capitalisation erodes a further 30% leading to a new base of 15-20 from the earlier 100 to 35-40 move. 

So what happens now? The company cannot raise equity capital for expansion plans. The companies have to pay a much higher rate of interest (explained below) for rolling over current deby. Most capital inflow now has to be in the form of debt or very unfavourable terms of equity dilution (which leads to further reduction in stock prices). The companies earnings come under pressure as a result of higher interest costs and adverse macroeconomic environment resulting from massive negative wealth effects on important segments of the economy - banks, consumers and producers. 

Clearly, if an economist from a corporate house issues such statements, he's not talking to the guys who run his company. 

For banks, in these times of panic, a precipitous decline in stock prices (as seen for Morgan Stanley, Lehman, Merill, Northern Rock, HBOS and our very own ICICI) normally initiates a run on the bank by customers. Not a good thing to happen as the run is almost guaranteed to destroy the bank - happened for all the above banks except ICICI. 

Take the case of auto companies in the US, their credit ratings have been downgraded partly because of the radical decline in stock prices. This causes yields on their debt to go up leading to further pressure on the balance sheet which leads to further credit concerns which leads to still higher yields, etc, eventually leading to a bankruptcy/takeover/bailout.

There are numerous current examples one can pick. 

An important caveat in valuing stocks - earnigs matter...but what really matters is the earnings multiple. When the sentiment turns negative, ceteris paribus,  the company which was trading at 20 times forward earnings just 2 days ago, will trade at 9 times forward earnings today. Whats happening in recent times is that earning estimates are being revise downwards by 10-30%...but company prices are being revised downwards by 60-80%. Keynes once said markets were driven by "animal spirits". Well, there's a fire in the credit markets and the animals are scared, very scared.





Shruthi Jayaram

Oct 29, 2008 at 6:08am

Great points, Varun. Thanks. Yes, thinking more regarding this - the impact of a decline in stock prices also have ripple effects on the net worth (and therefore, creditworthiness) other companies/individuals who hold those assets. This starts off a negative financial accelerator effect on lending and eventually, investment and growth.

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