Buffett indicators have been revised: market cap-to-GDP and valuation

“There are some limitations to the ratio when it comes to saying what you need to know. Still, this is probably the best single measure where the assessment stands at any given moment. “- Warren Buffett, 2001

Saudi Arabia’s stock market capitalization jumped from a near 100% of GDP on December 11, 2019 to a staggering 300%. Not at all. The only significant activity on the Saudi Stock Exchange was the listing of shares of a company that had recently completed a successful initial public offering (IPO).

That company was Saudi Aramco. Its valuation, 1.7 trillion. Or almost double the GDP of Saudi Arabia at $ 900 billion

What is the market cap-to-GDP ratio?

Simply put, the so-called Buffett indicator measures the total value of stocks traded publicly in a market divided by the GDP of that economy. Evaluation 101 teaches that the value of a stock is the current value of all its future earnings and cash flows. Thus, the stock market capitalization of a country is the sum of the present value of the combined future earnings of all its listed stocks.

GDP, meanwhile, is the monetary value of all final goods and services produced at a given time, usually a year. Presumably, if every economic activity in the country is corporate, GDP will basically reflect the total annual turnover of all companies.

In terms of these definitions, there are some differences between what numbers and denominations are measuring. Although GDP is limited by a time metric – one year – market capital is effectively looking for infinity. Furthermore, when the market is affected by capital gains, GDP is consistent with the annual turnover of companies. GDP is a flow variable, market capital is a stock variable.

So if GDP is related to the top line within a certain period of time and the stock markets are below the line for an indefinite period of time, then why compare the two?

To answer this we need to understand how GDP is measured. There are two approaches: by expenditure and by income. Both end at the same terminus: the monetary value of all final products and services produced.

The method of expenditure measures the money spent on goods and services, while the method of income measures the income earned from the production of goods and services. The basis of the latter approach is that in the manufacturing process, the total value of a good or service is entirely responsible for the factors of its production – land, labor, capital and entrepreneurship. Land gets rent, labor gets wages, and capital and entrepreneurs get interest and profits. GDP is a measure of total rent, wages and profits. Stock market capitalization largely depends on one of these factors: profit.

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Factor returns are cyclical.

The ingredients of the product are in constant competition to increase their prize and their share in the overall pie. The return of each factor depends on the existing socio-economic conditions and this share tends to change with the development of background conditions.

If the return of a certain factor increases over time, it is supplied more than it needs. This factor reduces earnings and thus its share in GDP. This demand-supply cycle leads to dynamic. The period of average average profit as a part of GDP is followed by the period of average profit below.

The Buffett indicator helps us think outside the box.

When corporate profits are increased, the price-to-earnings (P / E) ratio may seem reasonable, as higher share prices are divided into higher profits. But the stock market cap-to-GDP ratio will show a warning signal. If the share of profits goes back to its cyclically adjusted average, the stock markets will look overvalued.

The opposite applies during times of low corporate profitability and especially during severe economic downturns. At this point, earnings can be so disappointing that stock markets show exorbitant prices based on the P / E ratio, even in low market cap-to-GDP ratios. When profits recover their share in GDP and share prices rise together, the Buffett indicator will again appear to be a good performance indicator.

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But does market cap-to-GDP act as a thumb rule?

“The stock market capitalization-to-GDP ratio is a ratio that is used to determine whether an overall market is devalued or overvalued compared to a historical average. If the valuation ratio falls between 50% and 75%, the market can be modestly devalued. Also, the market can be fairly valued if the ratio falls between 75% and 90%, and if it falls between 90 and 115%, it can be modestly overvalued. উই Will Canton, Investopedia

So is the Buffett indicator relevant only to the US stock market or to other countries’ stock markets? Several considerations come to mind.

1. Comparisons across periods

In order to compare between different time periods for eligibility, the profit portion of the listed companies should be consistent with the profits of the listed companies. This does not mean that there is no new IPO. After all, new companies and sectors disrupt the old by ensuring creative destruction. If, in the process, the ratio of total profits flowing through the stock market remains largely stable, the ratio is effective.

But like Saudi Aramco, if high-profit sectors or companies are traditionally under-represented in the economy and listed later, comparisons over time become meaningless. In India, for example, if the country’s largest insurer, Life Insurance Corporation, goes public with an expected valuation of at least িয়ন 130 billion, India’s market cap-to-GDP ratio will increase by 5%.

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2. Compare country to country

These are usually helpless. The amount of economic activity that the stock market enters varies from one country to another. This deviation is true whether the countries are developed or developing, capitalist or (then) socialist.

German economic power is basically a function of it Middle class, For example. These small and medium-sized enterprises form the backbone of German industry. But at the end of 2001, the German market cap-to-GDP ratio was only 55%. In the United States it was about 150%. Yet the P / E ratio behind the DAX index was 25, roughly equal to the S&P 500.

3. Capital market size

If a particular capital market attracts a list of companies around the world, its buffet indicator can be quite inconsistent. Hong Kong SAR, China, a prime example: its ratio tends to run more than 1000%. In addition, as the size and number of cross-border transactions and global multinational companies (MNCs) increase, the relationship between a firm and its home market GDP worsens. For example, Tata Motors is listed in India, but its larger operations are through the UK-headquartered Jaguar Land Rover.

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4. Share of profit as a ratio of GDP

It varies from one economy to another. Profits make up a lot of Saudi Arabia’s GDP because its economy depends on the low-cost, high-profit oil industry. In 2018, Saudi Aramco led the world with a profit of 1 111 billion, which was about 12% of the country’s GDP, with the rest being a further part of the corporate sector. In the United States, between 2000 and the COVID-19 outbreak, corporate profits accounted for between 5% and 12% of GDP. In India, the range ranged from 2% to 4.5% over the same period.

Considering these factors, the rule of thumb does not seem to be universally applicable.

But what about Indian assessment?

A closer look at India’s Buffett indicator chart suggests that the market may be somewhat devalued. Currently, the ratio is about 70% as of January 28, 2021, or less than half of what it was in 2007.

But the ratio does not provide a complete perspective: it needs to be seen in the context of the profitability of Indian companies. And it’s not a pink picture.

Indian corporate profit-to-GDP ratio

Source: Business Today
Note: Statistics are for overall corporate profit, not specifically for listed companies.

Since 2008, profits have been steadily declining as a percentage of GDP. Although they stabilized in 201–201 with the outbreak of the Kovid-1 pandemic epidemic, the line went down again in 201–2020 and will probably continue until 2020–2021. Various factors have contributed to this decline, including the huge loan losses that financial institutions have had to deal with, higher corporate debt in some capital-intensive sectors, regulatory challenges facing some industries শক্তি energy producers, for example এবং and a general decline in economic growth.

Thus, those who believe that India is being devalued based on the Buffett indicator are either a rule based on their analysis that does not apply to India or expect a profit at the higher end of their historical range.

But is that profit scenario realistic? Even if the cycle is reversed, and profits start to rise, what does a sustainable level of profits look like for India in terms of the country’s socio-economic structure? Indeed, although Indian profits declined rapidly and steadily after reaching 7.7% of GDP in 2008–2008, the US corporate sector maintained its profit margins for a short period of time during the global financial crisis (GFC).

So let’s say that the sustainable level of profit in India has turned somewhere between the two extremes of 4.7% and 2%, say, 3.3%. This means that the stock markets have 20 times the P / E of long-term earnings. In that scenario, will India’s Buffett indicator be last, under or fairly valuable?

This is the answer to a difficult question. That is why further analysis is needed to determine the limitations of the Buffett indicator and applications for evaluation in India and around the world.

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All posts are the author’s opinion. As such, they should not be construed as investment advice, or the opinions expressed must not reflect the views of the CFA Institute or the author’s employer.

Photo Credit: © Getty Images / Dimitrios Camboris / Staff

Navin Bhohra, CFA

Navin Vohra, CFA, head of assessment, modeling and economics practice at Ernst & Young India. He has 25 years of experience in valuation and equity analysis.

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