De-jargoned: Market capitalisation to GDP ratio2 min read . Updated: 11 Oct 2017, 09:30 AM IST
Market capitalisation to GDP ratio is another ratio that helps to determine whether equity market is overvalued or not
In the recently held, 4th annual Mint Mutual Fund Conclave, when asked about the equity markets being expensive, Prashant Jain, executive director, HDFC Asset Management Company Pvt Ltd, said that the market is not expensive even at current levels. One of the factors he sighted for this conclusion was the low market capitalisation to GDP ratio. What is this ratio and why does it matter?
The market capitalisation of all the listed companies in the country divided by the gross domestic product (GDP) of the country gives us this ratio. For example, for the domestic market, the total market capitalisation for all stocks listed on the BSE is Rs135.75 trillion. India’s nominal GDP is Rs152.51 trillion. This gives us a market capitalisation to GDP ratio of around 89%.
This is another ratio that helps to determine whether equity market is overvalued or not. The idea behind it is simple: given that stock prices are derived from expected earnings for companies and the GDP represents consolidated revenue in the economy, this gives an estimate of whether the two are moving in tandem. A rough price to sales ratio is how one expert described it. A ratio above 100% shows overvaluation and one below 50% shows that the market maybe undervalued. The ratio was popularised by Warren Buffet around the time of the dotcom bubble and market crash.
In developed markets where contribution of various sectors is better represented in the listed stock market, such a ratio is considered accurate in determining valuations. However, in economies like India, the listed stock market does not have even representation from all sectors and this can lead to some variance in interpretation. Notably, the agricultural and unorganized services sectors are not well represented in the listed market space. Moreover, as newer companies get listed, this ratio is likely to get impacted; if the listing is of new-age businesses then the balance is maintained as these add incrementally to the overall GDP as well.
India’s market capitalisation to GDP ratio has been rising since FY13; however, it has not yet crossed the 100% mark since. Additionally, if you consider the ratio in the market peak of 2008, it was significantly above 100%. Looking at this, one may say that markets are not yet overvalued. However, the ratio should be seen more as an indicator and not in isolation. No one ratio is an accurate indication of market valuation. As a thumb rule, if the ratio is above 100%, there is greater need for caution in the markets.