What do you do in the market after the Nifty has corrected by nearly 30% and most individual stocks have fallen anywhere between 40-50%. One way is to use the Buffett indicator, also popularly known as the Market Cap to GDP ratio. Let us look at the concept first before applying the idea in the Indian context.
Understanding the concept of the Market Cap / GDP ratio
The Market Cap to GDP ratio (also known as the Buffett Indicator) is a measure of the total value of all publicly traded stock in a country, divided by that country’s Gross Domestic Product (GDP). GDP is the total income of the economy from all sources. It can also be seen as the value of all goods and services output in a particular year. Another way to look at GDP is to focus on the gross value added (GVA) which excludes the impact of taxes and subsidies. But we shall leave out that for the time being. The Buffett indicator is used as a broad way of assessing whether the country’s stock market is overvalued or undervalued, compared to a historical average. It is a form of Price/Sales valuation multiple for an entire country. Normally, 1 is the ideal ratio and anything below one means that the stock markets are undervalued. But this is more of a benchmark and ideally it must be compared to the historic average benchmarks.
What is the formula for Buffett Indicator?
The formula is quite simple as the name itself suggests. The formula can be written as under.
Market to GDP ratio (Buffett Indicator) =
This is the fraction view but normally, this number is multiplied by 100 to give the value of the Buffett indicator in percentage terms. The stock market cap to GDP ratio has become known as the Buffett Indicator in recent years as Warren Buffett had once commented to Fortune Magazine that he believes it is probably the best single measure of where valuations stand at any given moment. Buffett has admitted that he invariably uses this ratio as a measure of reasonableness of valuation. According to Buffett, this is a very simple and elementary way of looking at the value of all stocks on an aggregate level, and comparing that value to the country’s total output (which is its gross domestic product). This relates very closely to a price-to-sales ratio, which is a very high-level form of valuation. More importantly, this is in line with the fundamental thinking of Warren Buffett that behind every stock there is a business. Here we are looking at the value of all businesses at an aggregate level which is captured quite effectively by the GDP.
Applying the Buffett indicator in the Indian context
Data Source: MOSL
If the Buffett indicator is greater than 1.0x (or 100%) it is generally considered a sign of being relatively overvalued, while companies trading below 0.5x (or 50%) are considered to be cheap or undervalued. If you look back at the chart of the trend of the Buffett indicator in the Indian context, it has been close to the 50% level only thrice in the last 15 years. The first two instances were in 2005 and 2009 and both these situations marked the beginning of a multi-year bull rally. That is good news because the Buffett ratio is again back to that level and that gives hope that markets may actually be undervalued at these levels.
There are some shortfalls in the Buffett indicator
As much as the Buffett Indicator is a great high-level parameter, it has its own limitations. Here are some shortfalls you must be familiar with.
- This measure does not consider efficiency and profitability which are critical success factors in valuations of companies. Hence it can be misleading
- Secondly, there is no consensus on the appropriate benchmark and the consensus varies between 75% and 100%. That also can be quite confusing.
- Finally, this ratio is impacted by trends in Initial Public Offerings (IPOs), and the percentage of companies that are publicly traded (compared to those that are private).
That is something which could seriously vitiate the utility of the ratio. For example, countries like India could have a low ratio due to large parts of the economy being unlisted. On the other hand, the more penetrated markets in the US could also trade at a higher Buffett indicator. Nevertheless, the Buffett Indicator remains a good method to ratify findings on valuations at a macro level.
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