A pair months in the past, the macros that underpin equities seemed fully completely different — inflation was managed, rates of interest had been lowered and discretionary consumption was recovering effectively publish GST cuts. There didn’t appear to be any severe menace to earnings progress. Nonetheless, since March, the image has turned gloomy — oil value stays risky and elevated, monsoon might be under regular and better fertiliser prices might stoke meals inflation. These now forged uncertainty on regular supply of earnings progress by Indian corporations. In the meantime, geopolitics is the most complicated it has been in many years, including one other layer of uncertainty.
Since the battle broke out, markets have corrected to replicate this uncertainty however at the same time, fuelling discuss that this can be a good time to purchase, with valuations now under long-term averages. Nifty 50’s P/E dipped near 20x in March towards a 10-year imply of about 25x. At the moment, it trades at about 22x (niftyindices.com), having recovered from the backside in early April. However is each 22x Nifty P/E actually the same? That query issues extra when you think about the quietly rising price of fairness (CoE), which is usually missed.
CoE or the anticipated fee of return from equities is the low cost fee used to transform estimated future money flows to their current worth and is a key variable in valuation. Mathematically, for a given set of money flows, the next anticipated fee of return means a decrease valuation, and vice-versa. Logically too, this holds. Larger-risk property demand larger returns, and traders attempt to obtain this by paying a decrease entry value. Thus, in concept, there’s an inverse relationship between CoE and web current worth.
With that introduction to CoE out of the approach, allow us to circle again to the query. At the moment, Nifty trades at 21x earnings, simply because it did at the starting of CY04. Nonetheless, the CoE then was simply 9.9 per cent as towards right this moment’s 11.7 per cent (from 10.8 per cent as of January 1, 2026). The index’s EPS grew 50 per cent in CY04 over CY03 and it posted returns of 11 per cent. With such excessive earnings progress extremely unlikely in the mentioned macro backdrop, this improve in CoE additional indicators a chance of equities underperforming expectations in CY26.
On this story, we analyse 25 years of knowledge to watch whether or not the theoretical inverse relationship between valuation and CoE has held. However earlier than entering into the evaluation, it helps to know how CoE is computed — and who higher to study from than Professor Aswath Damodaran — the ‘Dean of Valuation’ himself.
The framework
Professor Damodaran’s CoE is broadly based mostly on the CAPM (capital asset pricing mannequin) equation: CoE = Rf + β * (Rm – Rf) the place,
Rf – risk-free fee of return, Rm – anticipated return of the broad inventory market and β – beta, a measure of relative threat of a portfolio versus the broad market portfolio (like S&P 500, as an illustration). The time period Rm – Rf can also be known as fairness threat premium (ERP).
Assume Rf, Rm and β at 5 per cent, 10 per cent and 1.2. CoE on this case would work out to 11 per cent (5 + 1.2 * (10-5)).
Damodaran’s strategy to every of those variables is completely different from the conventional approach of computing them and is logically sounder and right here is how it’s finished.
Threat-free fee
Textbooks recommend utilizing the yield on a long-term authorities bond in the same foreign money as the money flows being discounted. For rupee money flows, this may be the yield on the 10-year authorities safety.
Damodaran factors out a flaw right here. Even sovereigns carry default threat, nonetheless distant. Therefore, he suggests adjusting the sovereign yield for default threat utilizing its credit score default swap (CDS) unfold. A CDS works like insurance coverage — you pay a premium to be indemnified if the sovereign defaults. As an illustration, as of April 1, 2026, the CDS unfold on the 10-year Indian authorities bond was 1.02 per cent, and the bond yield stood at 6.96 per cent. Adjusting for this unfold provides a risk-free fee of 5.94 per cent. Damodaran takes this a step additional. He suggests utilizing solely the incremental CDS unfold over that of an Aaa-rated sovereign. The CDS unfold on a 10-year Swiss authorities bond (Aaa-rated) was about 0.17 per cent. The incremental unfold for India, subsequently, works out to 0.85 per cent (1.02 minus 0.17), yielding a risk-free fee of 6.11 per cent.
Nonetheless, this strategy is feasible provided that there’s an lively CDS marketplace for the foreign money. In case of its absence, he presents another — use the CDS unfold of a equally rated sovereign. India’s sovereign ranking by Moody’s is Baa3, and the CDS unfold for a Baa3-rated authorities bond then was about 2.09 per cent. Subtracting this from the Indian 10-year yield provides a risk-free fee of 4.87 per cent (6.96 minus 2.09).
Since we depend on Damodaran’s dataset (accessible persistently since 2001), we use this second strategy in our evaluation. Hyperlink to dataset > Threat Premiums for Different Markets.
Fairness threat premium
ERP (Rm – Rf) measures the extra return traders demand from equities over the risk-free fee. A easy strategy to estimate Rm is to make use of historic fairness returns, however this assumes the future will replicate the previous.
Damodaran as an alternative adopts a forward-looking strategy, computing an inside fee of return that reductions future money flows (dividends and buybacks) of a broad market index to its present degree.
Damodaran treats ERP as a sum of two unbiased parts:
(A) Mature market ERP — compensation for inherent threat of equities, no matter geography
(B) Nation threat premium — compensation for working in a particular market or geography
For the mature market, he makes use of the US and the S&P 500 as a result of the index presents strong historic knowledge and liquidity. Nonetheless, since Could 2025, the US is now not an Aaa-rated sovereign and has been downgraded to Aa1. Yet Damodaran sticks to the S&P 500 with a minor extra adjustment for this ranking downgrade, as there isn’t any equal broader market index in different Aaa-rated nations.
Allow us to stroll by how he calculates ERP for an rising market like India, as of April 1, 2026, as an illustration.
First, for Rm, with estimates of S&P 500’s money flows (dividends and buybacks) for the subsequent 5 years and a terminal worth (estimated to develop at the t-bond fee until perpetuity) Damodaran arrives at an IRR (inside fee of return) of 9.1 per cent that reductions these money flows to the present worth of the index. IRR is mainly the low cost fee that equates the current worth of future money flows to the present value of an asset. This forward-looking IRR serves as the Rm.
Subsequent up, ordinarily, one would use the 10-year US Treasury yield (4.3 per cent) as the Rf. Nonetheless, since the US is now not Aaa-rated, its Treasury yield features a ranking premium over that provided by a Aaa-rated sovereign. The CDS unfold for an Aa1-rated sovereign (US) was about 0.26 per cent. Adjusting for this, the true risk-free fee turns into 4.06 per cent, yielding a US ERP of 5.04 per cent (9.1 minus 4.06). Nonetheless, that is nonetheless not the mature market ERP (‘A’ from above). This 5.04 per cent features a small US-specific nation threat premium (‘B’ for US) of 0.26 per cent (CDS unfold). Eradicating this provides the pure mature market ERP, which works out to 4.78 per cent (A).
Subsequent comes India’s nation threat premium (India’s ‘B’).Damodaran largely suggests utilizing the same CDS unfold used to compute the risk-free fee earlier — on this case 2.09 per cent. Whereas this addresses the sovereign threat of the foreign money, different emerging-market dangers are left to be modelled solely by money flows, avoiding double counting of dangers.
Including A and B, India’s ERP works out to six.87 per cent (4.78 plus 2.09).
Summing up, with Rf at 4.87 per cent, ERP at 6.87 per cent, the CoE works out to 11.74 per cent as of January 1, 2026. In fact, ERP has to be multiplied with β, when working with a portfolio that’s smaller than the broader market portfolio. Nonetheless, since we’ve labored with the broader Nifty 500, we’ve skipped β right here.
Concept holds?
It ought to now be clear that there exists an inverse relationship between CoE and valuation. To see if this concept holds, we’ve constructed charts 1 and a pair of. Chart 1 maps the change in Nifty 500’s P/E (as of calendar year-ends) and the change in CoE for all calendar years since 2001. Chart 2 exhibits the absolute values of the index’s P/E and CoE (as of year-ends).
It can be seen from Chart 1 that the inverse relationship has largely held—in years the place CoE has fallen or stayed flat, P/E has expanded and vice-versa. Nonetheless, there are exceptions as a result of valuation is influenced not solely by CoE but in addition by earnings progress, sentiment and liquidity. Whereas earnings progress can be quantified, sentiment and liquidity are more durable to measure. As an illustration, 2021 was an outlier: CoE was unchanged, yet the P/E contracted over 40 per cent — from 43x (December 2020) to 25x (December 2021), as EPS surged 122 per cent from a low base in 2020.
On the different hand, in 2008, after the international monetary disaster, traders flocked to the security of presidency bonds, bringing down Rf and ultimately CoE. Ideally, valuation ought to have expanded. Nonetheless, P/E contracted 55 per cent owing to a bearish sentiment.
Let’s now deal with 2026. CoE has elevated 9 per cent up to now, from 10.8 per cent (January 1) to 11.7 per cent (April 1 – date of Damodaran’s newest launch). Valuation, on the different hand, has contracted simply 3 per cent, main one to doubt if the market is under-pricing dangers. Whether it is doing so, a late realisation might take the valuation a number of downward.
With the battle in West Asia yet to return to a significant conclusion, the price of oil stays elevated and extremely risky, adversely impacting India’s present account deficit, foreign money and inflation. It’s affordable to anticipate evening and day distinction between the common price of Indian crude basket in FY27 (April 2026 common was $114, for context) versus FY26 ($71 a barrel). This might erode margins of sectors akin to FMCG, paints, logistics, chemical substances, tyres, castings & forgings, and others which are depending on petroleum-based inputs. Elsewhere, base-metal costs are rising, AI disruption is actual and rural consumption stays closely weather-dependent, with El Niño and a possible rainfall-deficit posing draw back dangers. Monetary shares might see larger credit score prices pushed by attainable defaults in MSME and business automobile loans, denting earnings.
All these indicate extra uncertainty to earnings progress forecasts than lately. Once you mix larger CoE and earnings uncertainty, you have to take be aware {that a} Nifty 50 P/E of 22x now just isn’t the same as in one other previous 12 months when it was buying and selling at the same degree. Issue this in your funding selections. On this context, if earnings progress falters and thus valuations grow to be costly, a correction might observe in the end.
Printed on Could 9, 2026
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