Indian equities have been going through a lot of pain since September 2024 — as have investors.

Let’s zoom out a bit to understand how two metrics have, over the last few years, played decisive roles in bringing the market to this point: earnings growth and sales growth.

In the wake of the COVID-19 pandemic, Indian equities were riding high on strong earnings growth. The post-pandemic earnings recovery cycle lasted a while and significantly boosted market sentiment. This was reflected in share prices rising to higher PE multiples.

Why exactly did earnings rise during the post-pandemic period, though? One key reason was the sharp decline in various key costs, including raw material costs. This resulted in higher profit margins, as shown by the orange line in the chart below; currently, margins for the BSE 500 are still near their all-time high.

The other major contributor was sales growth. As the chart above reveals, top-line growth for the BSE 500 soared during 2021, and stayed above 20% for a considerable period.

Thus, good sales growth meant more revenue, and higher profit margins meant that more of that rising revenue was being converted into net profits (i.e. earnings).

And that brings us to the biggest short-term “worry” for the markets right now: the fact that both these levers have now reversed.

Companies across market caps are seeing a decline in terms of their EBITDA and EPS (earnings per share); the charts below1 indicate how this is true for the Nifty 200.

If earnings growth for the broader market mutes to 10-12%, valuation multiples must contract to reflect this reality and they are already contracting.

What’s also noteworthy is that earnings for the Small and Mid-cap (SMID) universe have shrunk particularly sharply, as can be seen in the chart below.

In effect, SMID valuations are now reverting to the mean, and where they stabilise depends partly on where earnings growth bottoms out. The possibility of such a scenario was one of the reasons why we repeatedly said that SMIDs lack an appreciable margin of safety.

For more actionable insights backed by data and analyses, we invite you to read the latest edition of Netra in its entirety.