“The ratio can only tell you so much of what you need to know. Still, it is probably the best single measure of what valuations look like at any given point in time.” — Warren Buffet2001
Saudi Arabia’s market capitalization jumped from around 100% of GDP to an astonishing 300% on December 11, 2019. Had the share prices of the country’s listed firms tripled overnight? Not in any respect. The only notable activity on the Saudi stock exchange was the listing of shares of an organization that had just accomplished a successful initial public offering (IPO) a number of days earlier.
This company was Saudi Aramco. It was price $1.7 trillion, or about twice Saudi Arabia’s GDP of around $900 billion.
What is the ratio of market capitalization to GDP?
Simply put, the so-called Buffett Indicator measures the full value of all publicly traded stocks in a market divided by that economy’s GDP. Valuation 101 teaches that the value of a stock is the current value of all future earnings and money flows. So a rustic’s market capitalization is the sum of the current value of all of the combined future earnings of all its publicly traded stocks.
GDP, however, is the monetary value of all final goods and services produced in a rustic during a given time frame (often a yr). So, hypothetically, if every economic activity in a rustic were organized into firms, GDP would essentially reflect the full annual turnover of all firms.
Given these definitions, there are some differences between what the numerator and denominator measure. While GDP is proscribed by a time metric – a yr – market capitalization effectively goes to infinity. While market capitalization is influenced by earnings, GDP corresponds to the annual sales of firms. GDP is a flow variable, market capitalization is a stock variable.
So if GDP looks at sales over a certain time frame and stock markets take a look at profits over an infinite time frame, why compare the 2?
To answer this query, we want to know how GDP is measured. There are two approaches: expenditure measurement and income measurement. Both result in the identical result: the monetary value of all final goods and services produced.
The expenditure approach measures the cash spent on goods and services, while the income approach measures the income earned by producing goods and services. The premise of the latter approach is that within the production process, the full value of an excellent or service is entirely attributable to the aspects of its production – land, labor, capital, and entrepreneurship. Land yields rent, labor yields wages, and capital and entrepreneurship yield interest and profits. The measure of total rent, wages, and profits is GDP. Stock market capitalization depends largely on only one in all these components: profits.
Factor returns are cyclical.
Factors of production are in constant competition to extend their returns and their share of the general pie. The returns of every factor depend upon the prevailing socio-economic conditions, and this share is consistently changing because the environment changes.
If the return on a specific factor increases over time, there will probably be more of it supplied than there may be demand for it. This reduces the return that the factor generates and thus its share of GDP. This demand-supply dynamic results in cycles. Periods of above-average profits as a share of GDP are likely to be followed by periods of below-average profits.
The Buffett Indicator helps us think beyond the cycle.
When corporate earnings are high, the price-to-earnings (P/E) ratio could appear reasonable, as high stock prices are divided by high earnings. However, the market capitalization-to-GDP ratio will probably be a warning sign. When the earnings ratio falls back to its cyclically adjusted average, equity markets will appear overvalued.
The opposite is true in periods of low corporate profitability, and particularly during severe economic downturns. During these times, earnings will be so low that stock markets appear overvalued on a P/E basis, even at low market cap-to-GDP ratios. When earnings regain their share of GDP and stock prices rise in lockstep, the Buffett Indicator once more appears to be a greater performance indicator.
But does the market capitalization to GDP ratio work as a rule of thumb?
“The stock market capitalization to GDP ratio is a metric used to determine whether an overall market is undervalued or overvalued compared to a historical average. If the valuation ratio is between 50% and 75%, the market can be said to be slightly undervalued. Additionally, the market can be fairly valued if the ratio is between 75% and 90%, and slightly overvalued if it is in the range between 90% and 115%.” — Will Kenton,
So is the Buffett indicator only relevant for the US stock market or also for the stock markets of other countries? Several considerations come to mind.
1. Comparisons over different periods
For comparisons over different periods to be meaningful, the share of profits of listed firms should be broadly consistent with the share of profits of unlisted firms. This doesn’t mean that there are not any recent IPOs. After all, creative destruction ensures that recent firms and sectors disrupt the old ones. If during this process the share of total profits flowing through equity markets stays broadly constant, the ratio is beneficial.
But as within the case of Saudi Aramco, for highly profitable industries or firms which are traditionally underrepresented within the economy and go public later, cross-period comparisons are meaningless. In India, for instance, the country’s market capitalization would increase by 5% if the country’s largest insurer, Life Insurance Corporation, went public with an expected valuation of at the very least $130 billion.
2. Country comparisons
These are generally not helpful. The extent to which stock markets intervene in economic activity varies from country to country. This divergence applies no matter whether the countries are developed or developing, capitalist or (formerly) socialist.
Germany’s economic strength is basically a function of its . These small and medium-sized enterprises form the backbone of German industry. But the ratio of German market capitalization to GDP was only 55% at the top of 2019.In the USA, the figure was around 150%. However, the P/E ratio of the DAX index was 25, which was concerning the same because the S&P 500.
3. Size of the capital market
When a specific capital market attracts firms from all around the world to go public, its Buffett Indicator will be quite disproportionate. The Hong Kong Special Administrative Region in China is a primary example: its ratio tends to be above 1000%. Moreover, the connection between an organization and its home market GDP weakens as cross-border transactions and the scale and variety of multinational firms (MNCs) increase around the globe. For example, Tata Motors is listed in India, but its larger business operations are conducted through Jaguar Land Rover, which is headquartered within the UK.
4. Profit share as a share of GDP
This varies from economy to economy. In Saudi Arabia, profits make up a big portion of GDP since the country’s economy is determined by the low-cost and lucrative oil industry. In 2018, Saudi Aramco was the world leader with profits of $111 billion. which accounted for about 12% of the country’s GDP, with the remaining of the company sector contributing one other share. In the United States, the full share of corporate profits ranged from 5% to 12% of GDP between 2000 and the COVID-19 outbreak. In India, the range was between 2% and 4.5% through the same period.
Taking these aspects into consideration, this rule of thumb doesn’t appear to be universally applicable.
But what concerning the Indian rankings?
A primary take a look at India’s Buffett Indicator chart suggests that the market could also be somewhat undervalued. Currently, the ratio is around 70% as of January 28, 2021, lower than half of what it was in 2007. Since 2015, the ratio has been moving in a comparatively narrow band.
But this metric alone doesn’t provide an entire perspective: it should be viewed within the context of Indian corporate profits. And that just isn’t a rosy picture.
Indian Corporate Profit to GDP Ratio
Note: The statistics consult with total corporate profits, not specifically to the profits of listed firms.
Since 2008, profits as a percentage of GDP have been steadily declining. While they stabilized in 2018-2019 with the onset of the COVID-19 pandemic, the road has trended downward again in 2019-2020 and can likely achieve this again in 2020-2021. Several aspects have contributed to this deterioration, including the massive loan loss provisions that financial institutions have had to establish, high levels of corporate debt in some capital-intensive sectors, the regulatory challenges facing certain industries – energy producers, for instance – and the final decline in economic growth.
So anyone who believes that India is undervalued based on the Buffett Indicator is either basing their evaluation on a rule of thumb that won’t apply to India or is expecting earnings to return to the upper end of their historical range.
But is that this profit scenario realistic? Even if the cycle reverses and profits begin to rise again, what’s a sustainable level of profits for India, given the country’s socio-economic structure? While Indian profits have indeed declined sharply and repeatedly after peaking at 4.7% of GDP in 2007-2008, the US corporate sector has been able to keep up its profit ratio, apart from a temporary dip through the global financial crisis.
So let’s assume that the sustainable earnings level in India is somewhere in the course of the 2 extremes of 4.7% and a pair of%, i.e. around 3.3%. This implies that the equity markets are trading at 20 times the P/E of long-term earnings. Will India’s Buffett Indicator be over-, under- or fairly valued on this scenario?
This is a difficult query to reply and further evaluation is required to find out the restrictions and areas of application of the Buffett Indicator for valuations in India and globally.
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Photo credit: ©Getty Images / Dimitrios Kambouris / Staff
