Are Small Cap stocks really overvalued?

Recently, there has been a lot of chatter about the overvaluation in the small cap segment and subsequent correction that we have witnessed. During such times, it is very important to keep our emotions aside and look at the right data to make informed decisions.

While one can look at various metrics for valuations such as Price to Earning (PE) ratio, Price/earnings-to-growth (PEG) ratio, Price to Book (PB) ratio among others to analyze these stocks in detail, the most commonly used is PE ratio.

For the purposes of our analysis and simplicity, we shall look at the PE of the Nifty Smallcap 250 Index that encompasses the small cap universe to get a sense of how valuations are.

As depicted in the table below, we can see that as on 14th February 2025, we are at a value lower than the Median Value of last 5 years:

Metric	Current Value as on 14 Feb 2025	Median Value of last 5 years
Trailing PE for Nifty Smallcap250	27.5	28.9

Now, if we drill down further and look at each stock, one will see how the number is skewed on the higher side due to 18 specific stocks having PE of more than 100.

In fact, just the top 3 names in the list below with an average market capitalization of ~ INR 17,900 crores have an average PE of more than 1000.

Source: Screener.in

S.No.	Name	CMP Rs.	P/E	Mar Cap Rs.Cr.
1	Devyani Intl.	158	1424	19094
2	A B Real Estate	2069	1267	23106
3	Westlife Food	725	994	11306
4	Piramal Pharma	185	467	24513
5	Sapphire Foods	300	391	9622
6	PTC Industries	13083	381	19604
7	Sterling & Wils.	261	222	6085
8	Sobha	1161	204	12410
9	SignatureGlobal	1168	202	16411
10	Chalet Hotels	694	150	15151
11	Laurus Labs	546	147	29449
12	Rajesh Exports	159	122	4684
13	Mahindra Life.	359	117	5560
14	Astrazeneca Phar	7104	106	17759
15	Honasa Consumer	222	106	7220
16	The Ramco Cement	845	102	19958
17	Suven Pharma	1090	99	27739
18	Kaynes Tech	4008	99	25658
19	IFCI	45	98	11657
20	Amber Enterp.	5817	89	19676
21	Radico Khaitan	2043	88	27335
22	TBO Tek	1617	82	17563
23	Netweb Technol.	1409	79	7983
24	GE Vernova T&D	1475	77	37762
25	Century Plyboard	751	77	16694

When one excludes these stocks with PE above 100, the index PE ratio contracts to ~ 26.20, signaling valuations ~ 10% below the historical median average levels.

Market Correction Insights

Let us now look at the price corrections within the Nifty Smallcap 250 Index from their 52-week highs:

Correction Range from 52 Week High	Number of stocks	% of Small cap 250 Index
Up to 15% Correction	16	6.40%
15% - 30% Correction	81	32.40%
30% + Correction	153	61.20%
Total	250	100%

This shows that over 60% of the small-cap universe has corrected by 30% or more creating favorable valuations for stocks. However, since the stock market is a forward-looking machine, it is necessary to combine this study with the future earnings growth potential of each stock to make an informed decision.

Conclusion:

Our study shows that valuations are now fair and one should start considering the small cap space for investments in a staggered manner. A few things to keep in mind -

• Small-cap investments require patience. A minimum holding period of 5 years is essential to ride out volatility and capture long-term growth.

• It is crucial that one does not jump and buy any small cap equity fund simply by looking at past historical returns but rather conduct a thorough study of the constituents of the fund to prevent from investing in under-performing funds.