Market Cap to GDP Ratio Close to 100%

Dec 28, 2017

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We generally refer to PE or price to earnings ratio to gauge whether the market is undervalued or overvalued. If we go by this ratio, the Indian market is clearly in overvaluation territory. The Sensex and the Nifty trading at a PE of 25 and 26.9 times respectively. The midcap and smallcap indices are trading at insane valuations at PEs of around 46.4 and 113.8 times. Mid and small caps have never seen such crazy valuations.

There is still another ratio, which is frequently used to evaluate the valuations. The market capitalization to GDP ratio. It is one of Buffett's favourite indicators of broader market value. The market cap of all the listed companies in the country divided by the gross domestic product (GDP) of the country gives us this ratio.

The idea behind this ratio is simple. Stock prices are derived from expected earnings for corporates and GDP represents revenue of the country. This gives investors an estimate of whether the two are moving in tandem. A ratio above 100% shows overvaluation and one below 50% shows that the market may be undervalued.

Even this ratio is showing valuations reaching its peak levels. India's market cap to GDP ratio reached 95%. This ratio was more than 100% after the 2007 bull run. Stock prices had seen a significant meltdown after that amid the global financial crisis.

The expansion in market cap was the result of a considerable re-rating of a majority of stocks in the last 12-18 months. Besides the sharp share price increase, high equity issuances, particularly initial public offerings (IPOs), have contributed to the increase in market cap this year. Despite re-rating, earnings are yet to stack up. This may make stock prices unsustainable at higher levels.

2018 will, therefore, be critical for Indian companies to justify their valuations with earnings growth. Investors must remain cognizant about valuations and ensure they take some profits off the table whenever the opportunity is ripe for the picking.

Data Source: RBI, BSE, Business Standard
*FY18-as on 26 Dec 2017

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