This Warren Buffett valuation indicator is flashing red for Indian equities

India’s equity valuations measured using market capitalisation-to gross domestic product (GDP) ratio have risen significantly above their historical average.

Also known as the Warren Buffett indicator, after he said “it's probably the best measure of where valuations stand at any given moment”, the measure is estimated at 104% for the current fiscal, pointed out Motilal Oswal Securities Ltd. This is well above the historical average of 79%. As the name suggests, this ratio is derived by using the total market cap of a country’s listed stocks as the numerator and GDP as the denominator.

What does this mean? Analysts say, this signals rich valuation of Indian stocks, but most likely factors in a recovery in the near future given the pandemic-led slowdown in India's economic growth.

India's GDP growth is poised for a recovery but the robust rally in Indian stock markets could keep this ratio at elevated levels. Delayed revival in corporate earnings and a potential third wave remain keys risks to the ongoing up move in Indian stocks, analysts said.

Indian stocks are expensive even when one looks at the valuations taking into account the price-to-earnings (PE) ratio. Bloomberg data shows that the MSCI India index is trading at a one-year forward PE of around 20 times, higher than MSCI Asia ex-Japan's 15 times PE multiple. Even though there has been some moderation in India's valuations from the recent peaks, it remains an expensive bet compared to most emerging market peers.

Analysts at BofA Securities point out that Nifty's two year forward PE at 19 times is at a peak, and an 8% premium to long-term average, thus limiting future upside. The foreign brokerage house is of the view that expensive valuations are one of the key dampeners for Indian equities. Taper talks in the US, potentially higher US bond yields and dollar, consensus earnings per share cuts, recent muted IPO gains hurting retail investor sentiment could act as negative triggers, they said in a report on 20 August.