“The ratio has some limitations in telling you what you need to know. Yet it is probably the best single measure of where valuations are at any given time. — warren buffet2001
Saudi Arabia’s market cap jumped from around 100% of GDP to an astonishing 300% on December 11, 2019. Had stock prices of listed companies in the country tripled overnight? No way. The only notable activity on the Saudi stock exchange was the listing of shares of a company that had just completed a successful initial public offering (IPO) a few days earlier.
That company was Saudi Aramco. Its valuation, $1.7 trillion. That’s about twice Saudi Arabia’s GDP of about $900 billion
What is the market capitalization to GDP ratio?
Simply put, the so-called Buffett Indicator measures the total value of all publicly traded stocks in a market divided by the GDP of that economy. Valuation 101 teaches that the price of a stock is the present value of all its future earnings and cash flows. Thus, the market capitalization of a country is the aggregate of the present value of all the combined future earnings of all its listed stocks.
GDP, on the other hand, is the monetary value of all final goods and services produced in a country during a given period, usually a year. So, hypothetically, if all economic activities in the country were privatized, GDP would essentially reflect the aggregate annual turnover of all businesses.
Given these definitions, there are some differences between what the numerator and the denominator measure. While GDP is bounded by a time metric – one year – market cap effectively looks to infinity. Moreover, while market capitalization is influenced by profits, GDP corresponds to the annual turnover of companies. GDP is a flow variable, market capitalization a stock variable.
So, if GDP is about turnover over a defined period and stock markets are about earnings over an infinite period, 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 the final goods and services produced.
The expenditure approach measures the money spent on goods and services, while the income approach measures the income earned from the production of goods and services. The premise of the latter approach is that in the process of production, the total value of a good or service is entirely attributable to the factors of its production – land, labor, capital and entrepreneurship. Land brings rent, labor brings wages, and capital and entrepreneurship bring interest and profits. The measure of rent, wages and aggregate profits is GDP. Market capitalization largely depends on just one of these components: earnings.
Factor returns are cyclical.
The factors of production are in constant competition to increase their rewards and their share of the overall pie. The returns to each factor depend on prevailing socio-economic conditions, and this share keeps changing as background conditions change.
If the yield of a particular factor increases over time, more of it is supplied relative to its demand. This reduces the return that the factor earns and therefore its share in GDP. This supply-demand dynamic leads to cycles. Periods of above-average profits as a percentage of GDP tend 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 may seem reasonable because high stock prices are divided by high earnings. But the market cap to GDP ratio will trigger a warning signal. If the earnings share returns to its cyclically-adjusted average, equity markets will look overvalued.
The reverse applies in periods of weak corporate profitability, and especially during severe economic downturns. In these times, earnings can be so depressed that stock markets appear overvalued based on P/E ratios, even against the backdrop of low market cap-to-GDP ratios. As earnings recover their share of GDP and stock prices rise in tandem, the Buffett indicator would once again seem like a better performance indicator.
But does the market cap-to-GDP ratio work as a rule of thumb?
“The market cap-to-GDP ratio is a ratio used to determine whether an overall market is undervalued or overvalued relative to a historical average. If the valuation ratio is between 50% and 75%, we can say that the market is slightly undervalued. In addition, the market may be fair valued if the ratio is between 75% and 90%, and slightly overvalued if it is between 90 and 115%. — Will Kenton, Investopedia
So is the Buffett indicator only relevant for the US stock market or for the stock markets of other countries as well? Several considerations come to mind.
1. Comparisons between periods
For comparisons over different periods to be valid, the share of profits of listed companies must be broadly consistent with the profits of unlisted companies. That doesn’t mean there won’t be new IPOs. After all, creative destruction ensures that new businesses and new industries disrupt old ones. If during this process the proportion of aggregate profits going through stock markets is broadly constant, the ratio is useful.
But as with Saudi Aramco, if high-yielding sectors or companies have traditionally been underrepresented in the economy and then traded publicly, comparisons between time periods become meaningless. In India, for example, if the country’s largest insurer, Life Insurance Corporation, went public, with an expected valuation of at least US$130 billion, India’s market cap-to-GDP ratio would increase by 5%.
2. Country comparisons
These are usually unnecessary. The degree of penetration of stock markets in economic activities varies from country to country. This divergence is true whether countries are developed or developing, capitalist or (formerly) socialist.
Germany’s economic power is largely a function of its Mittelstand, For example. These small and medium-sized enterprises form the backbone of German industry. But Germany’s market cap-to-GDP ratio was only 55% at the end of 2019.. In the United States, it was around 150%. Still, the DAX’s P/E ratio was 25, about the same as the S&P 500.
3. Capital market size
If a particular financial market attracts quotes from companies around the world, its Buffett indicator can be quite disproportionate. Hong Kong SAR, China, is a prime example: its ratio tends to exceed 1,000%. Moreover, as cross-border transactions and the size and number of multinational enterprises (MNEs) increase around the world, the relationship between a company and the GDP of its home market weakens. For example, Tata Motors is listed in India, but its larger operations are through Jaguar Land Rover, which is headquartered in the UK.
4. Share of profits as a proportion of GDP
This varies from economy to economy. Profits make up a large portion of Saudi Arabia’s GDP since its economy depends on the low-cost, high-profit oil industry. In 2018, Saudi Aramco led the world with $111 billion in profits, which accounted for about 12% of the country’s GDP, with the rest of the business sector contributing an additional share. In the United States, between 2000 and the COVID-19 epidemic, the total share of corporate profits varied between 5% and 12% of GDP. In India, the range was between 2% and 4.5% over the same period.
Given these factors, the rule of thumb does not seem universally applicable.
But what about Indian valuations?
A first look at the Indian Buffett indicator chart suggests that the market may be somewhat undervalued. Currently, the ratio is around 70% as of January 28, 2021, less than half of what it was in 2007. The ratio has been moving in a relatively narrow band since 2015.
But the ratio by itself does not provide a complete perspective: it must be seen in the context of Indian corporate earnings. And it’s not a rosy picture.
Indian corporate earnings to GDP ratio
Since 2008, profits have steadily declined as a percentage of GDP. While they stabilized in 2018-2019, with the outbreak of the COVID-19 pandemic, the line fell again in 2019-2020 and will probably continue in 2020-2021. Various factors have played into this deterioration, including the huge loan loss provisions that financial institutions have had to build up, the high degree of corporate indebtedness in certain capital-intensive sectors, the regulatory challenges faced by certain industries – energy producers, for example – and the general decline in the rate of economic growth.
Thus, those who think India is undervalued based on the Buffett indicator are basing their analysis on a rule of thumb that may not apply to India or expecting profits to revert to the upper end of their historical range.
But is this profit scenario realistic? Even if the cycle reverses and profits start to rise, what does a sustainable level of profits look like for India given the country’s socio-economic structure? Indeed, while Indian profits have fallen sharply and steadily after peaking at 4.7% of GDP in 2007-2008, the US corporate sector has maintained its profit ratio, except for a short duration during the global financial crisis (GFC).
So let’s assume that the sustainable level of profits in India is somewhere in the middle of the two extremes of 4.7% and 2%, say 3.3%. This implies that stock markets are at 20 times the P/E of long-term earnings. In this scenario, will the Indian Buffett indicator be overvalued, undervalued or even?
This is a difficult question to answer. This is why further analysis is needed to determine the limitations and applications of the Buffett indicator for valuations in India and globally.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
Image credit: ©Getty Images / Dimitrios Kambouris / Staff
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