One parameter that fund managers and investment experts cite in support of their belief that the market is not expensive at current levels is the market capitalisation to GDP ratio which is less than 100%. However, what exactly is the significance of this ratio?
What is Market Capitalisation to GDP ratio?
Simply put, the market capitalisation to GDP ratio helps determining whether the equity market is overvalued. V. Balasubramanian, Head of Equity, IDBI Asset Management Limited said, “Very often, when the stock market is rising, the valuations begin to look pricey. That is when you look at market capitalisation to GDP ratio to find relative valuation of the market. It gives you a comfort that even though the market reaches its record high, there is more room to grow.”
The stock prices are derived from expected earnings and outlook of companies while the GDP represents consolidated revenue in the economy. This ratio gives an estimate of whether the two are moving proportionally.
It is calculated by dividing the market capitalisation of all the listed companies in the country by the gross domestic product (GDP) of the country. For instance, for the domestic market, the total market capitalisation for all stocks listed on the BSE is Rs. 138 lakh crore whereas India’s nominal GDP is Rs.153 lakh crore. This gives us a market capitalisation to GDP ratio of around 90%. Therefore, the market can still grow by another 10% before it hits the ‘fair value’.
It is also known as the ‘Buffet Indicator’ as Warren Buffet believes it is probably the best single measure of where valuations stand at any given moment.
Shortcomings of the Buffet indicator
Ideally, a ratio of less than 100% signifies that the market is not overvalued and has more room to grow. However, one cannot come to a conclusion only after looking at a single ratio.
There are other parameters as well that one needs to consider, especially for a developing nation like India where the contribution of different sectors is not very well represented in the stock markets. In fact, in India, around 17% of the GDP contribution comes in from the agricultural sector where as barely 50 agricultural companies are listed on the stock exchanges.
Also, 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).
