This sustained decline in the Indian stock market comes on the heels of the United States' announcement of possible new tariffs. President Donald Trump has announced his intention to introduce reciprocal tariffs against nations that impose taxes on products imported from the USA. According to analysts, these proposed tariffs could deter foreign investors from placing their capital in India, accentuating the risk of a slowdown in international investment flows to the country.
As a reminder, the Nifty 50 closed 2024 up 8.8%, marking its ninth consecutive year of growth. Against a backdrop of post-pandemic recovery and sustained economic reforms, India's large caps have attracted strong investor interest in recent years.
Against a backdrop where the Indian index hit its highs last September, and has been on a steady downtrend ever since, it seems interesting to calculate the Equity Risk Premium (ERP) of the Indian market, i.e. the expected return for an investor wishing to take a position. Here, I will use Professor Aswath Damodaran's method to calculate what is known as the "Implied Equity Risk Premium".
But before going any further, let me tell you a little about the concept of ERP. The risk-free rate (Rf) in India today is 6.686%. This is the yield on a 10-year Indian government bond in Rupee.
Now, what is the average return we expect from our stock market? According to Bloomberg, the average expected return of the Nifty 50 is 12% per annum over the long term, which corresponds to our market return (Rm). The difference between our expected market return and the current risk-free rate becomes the risk premium:
ERP = Expected market return (Rm) - Risk-free rate (Rf)
ERP Nifty 50 = 12 (Expected return) - 6.686 (10 Year Indian Gov Bond) = 5.314%.
Consequently, the risk premium of our index is 5.314% (= 12% - 6.686%). As a rule of thumb, investors expect a risk premium of around 5.3% when investing in equities, i.e. the index should yield 5.3% more than the risk-free return.
This is a generic example, we'll now go further.
The implicit equity risk premium
In the previous example, we generally assumed that the Nifty-50 index would offer a return of 12%. However, consider the current environment: the Nifty 50 has fallen almost 13% from its all-time high of 26,277.35 reached in September 2024, due to two consecutive weak earnings seasons, persistent foreign capital outflows and global trade concerns.
Although brokers are optimistic and expect a recovery to 26,000 by the end of 2025, we're entitled to ask: isn't the Indian market overvalued after this golden decade?
To answer this question, we're not going to use financial ratios or estimate the intrinsic value of our index. Here, I'll be using Professor Aswath Damodaran's method, subsequently calculating what's known as the "Implied Equity Risk Premium", which is a valuation method that allows us to determine whether or not a stock, index or equity fund is worth investing in.
This method consists of considering the index as a company, and simply valuing its cash flow using a Dividend Discount Model. Except that these cash flows will actually be the dividends and buybacks that the companies in the index plan to make. In our case, we'll omit buybacks because of the difficulty of obtaining reliable data (especially as they are rather low among Nifty companies).
According to Bloomberg, we have the estimated projections (in terms of earnings and dividend per share) from the analyst consensus for our index:
Solving the equation below :
We find D = 6.35%. This means that by investing at current levels (22,945.3 points) in the Nifty 50 index, we can expect an expected return of 6.35%.
Returning to our original ERP formula, we find :
Implied ERP = 6.35 - 4.577 = 1.773%.
How do we interpret this risk premium?
If you think that the risk premium on equities today (1.773%) is too low, you're taking the de facto view that equities are overvalued, and if, on the contrary, you consider it too high, you're taking the opposite position.
At the start of this analysis, we estimated that for the Nifty 50, investors expect to earn a risk premium of around 5.3%. This means that, if the current 5-year risk-free rate (from which we substract the CDS spread for Indian Rupee which is 2.18%) is 4.577%, investors will be satisfied with a return of between 12% and 13% on the stocks making up our index.
It would therefore appear that the Indian market is overvalued, or at the very least, fairly valued at present. The index has a fairly high P/E of 21.34x. We have calculated that, at current index levels (22,945.3 points), the equity risk premium will only be 1.773% higher than the risk-free rate. However, it should be noted that my estimate is conservative because it assumes that the index reflects the value of the dividends that shareholders will receive, it does not take into account reinvestments, and therefore the potential creation of value. That is why my estimate based on profits would give me a premium of 5.45%, which still seems too low to me, given that the current premium on the US market is 4.33%.
