Market Cap to GDP Ratio (The Buffett Indicator)

Market Cap to GDP Ratio (Buffett Indicator)

Market Cap to GDP Ratio (The Buffett Indicator)

Limitations of The Buffett Indicator

Introduction

Market Cap to GDP Ratio, also popularly known as the Buffett Indicator is used to assess the valuations of the stock markets of a country. Let us discuss what does this valuation metric tell, how to interpret the ratio, what are the limitations of The Buffett Indicator in the Context of Indian Market Valuation etc.

Market Cap to GDP Ratio | The Buffett Indicator

Market Cap to GDP Ratio | The Buffett Indicator
Market Cap to GDP Ratio | The Buffett Indicator

Meaning

  • Market Cap to GDP Ratio is a valuation metric which is used for assessing whether the country’s stock market is overvalued or undervalued, compared to its historical average.
  • The ratio has become known as the Buffett Indicator in recent years, after the investor Warren Buffett popularized its use. Warren Buffett believes that Market Cap to GDP Ratio is one of the best measure of where valuations of the market stand at any given moment.
  • As per Buffett’s comment, the ratio is a simple way of looking at the value of all the listed stocks on an aggregate level, and comparing that value to the country’s total output (which is its gross domestic product).  

Formula

  • Market Cap to GDP Ratio = (Value of All Listed Stocks in a country / GDP of the country) * 100
  • Thus, It is a measure of the total value of all publicly traded stock in a country, divided by the country’s Gross Domestic Product (GDP).

Interpreting Market Cap to GDP ratio

  • If the Ratio is :
    1. 50% to 75%, the market is said to be modestly undervalued
    2. 75% to 90%, the market may be fair valued
    3. 90% to 115%, the market is said to be modestly overvalued
  • The Buffett indicator is like a Price-to-Sales ratio for the entire country.  It relates very closely to a price-to-sales ratio, which is a very high-level form of valuation.
  • In valuation, the Price/Sales or EV/Sales ie.(Enterprise Value/Sales) metric is used as a measure of valuation.
  • A Price/Sales ratio of greater than 1.0x (or 100%) is generally considered a sign of being overvalued. On the otherhand, companies trading below 0.5x (or 50%) are considered to be undervalued.
  • In order to properly assess a company’s valuation, other factors have to be taken into consideration, such as margins, growth etc.
  • This is consistent with the interpretation of the Buffett Indicator, which makes sense, since it’s essentially the same ratio, for an entire country instead of for just one company.

Limitations of The Buffett Indicator

  • The market only encompasses the value of all the listed companies in the country. But the GDP is the value of all incomes which includes unlisted private companies, small businesses, MSMEs, proprietorships, partnerships, government companies, government departments etc. To that extent the numerator and the denominator are not entirely comparable.
  • The ratio is impacted by :
    1. Trnds in Initial Public Offerings (IPOs) and
    2. Percentage of companies that are publicly traded (compared to those that are private).  All else being equal, if there was a large increase in the percentage of companies that are public vs private the Market Cap to GDP ratio would go up, even though nothing has changed from a valuation perspective.
  • The applicability of the buffett indicator is higher when the market cap reflects a much larger share of economic activity in the country. That is why the ratio is widely used in the advanced/developed countries like the US, UK, Singapore, Germany, Sweden where more of business comes under the formal sector.

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