Before leaving for a long journey, we make sure that the car’s fuel tank is full, the tyres are filled with air, the car has oil, and the battery is fully charged. Also, we check that all the indicators in the car’s panel are working fine and when all the things are in place, we set out on the journey. Similarly, while beginning the journey of investing, we should first check all the indicators that depict the share market valuation. So which are those five essential indicators that are necessary that further help in the analysis of market valuation required for the planning of investments. Let us find out.
The first indicator which you’re supposed to check is Warren Buffet Indicator. One of the world’s most successful investors Warren Buffet has mentioned about the indicator which is Market Cap to GDP Ratio. So what is this Market Cap to GDP Ratio? We have already covered this in a separate blog, if you haven’t checked it yet, do give it a look.
So Warren Buffet quotes, “If the share market cap of any country in the world is more than the country’s GDP then the market valuation is expensive. Also, if the share market cap of any country becomes twice the GDP of that country then investing in such a market is equivalent to playing with fire is what Warren Buffet believes. If we analyze the current data of the US market we find that the Market Cap to GDP ratio has reached the level where investing there is almost equivalent to playing with fire. Also, talking about India, recently there was a headline in the newspaper that the figures of Market Cap to GDP ratio are indicating towards an expensive market valuation.
Now, let us take you through an important analysis. In Market Cap to GDP ratio, we divide the Market Cap by the GDP Ratio. Consider, the market cap is 100 and the GDP which is the total of the entire production taking place in the country is also 100. So 100 / 100 = 1. That means the market cap of the country has reached the level of the country’s GDP. So here, if the production is halted temporarily due to any reason or comes down to half like during the times of corona when the production had almost come to a standstill.
Let us consider, the production had fallen to half of its actual level. Consider, the market cap is 100 and GDP has fallen to its half, i.e. 50. Now, 100 / 50 = 2. That means the market cap has become twice the GDP indicating towards an expensive market valuation. But here we knew that the fall in GDP was a temporary phase and as soon as the lockdown ends, the GDP would increase again. Consider, if the GDP again increased from 50 to 100 then 100 / 100 = 1. So if the GDP increases further from here then the market valuation may move towards being inexpensive. But here we assumed that in all the cases the market cap was 100. When the GDP increases from 50 to 100 and in the meantime if the market cap too increases then consider if the GDP increases from 50 to 100 as well if the market cap increases from 100 to 200 then 200 / 100 = 2. That means even though the GDP increased but because there was an increase in the market cap as well, the market again went up to a higher valuation. Thus, as per the market cap to GDP ratio, the market valuation is expensive. In this manner, if you wish to invest systematically for the long-term then to analyze the market valuation, you can make use of the Warren Buffet Indicator / Market Cap to GDP Ratio.
The second, as well as an important indicator which you should refer to, is the Nifty PE ratio. PE Ratio means Price Earning Ratio. PE ratio tells us how much we need to pay to earn one rupee. For example, if we analyze the latest data, we find that the Nifty PE is currently close to 40. That means we are supposed to pay Rs. 40 to earn Re. 1. The earning yield is 2.5% here. This earning yield is very less compared to the bankʹs interest rate. In this manner, if we analyze the Indian share market using the Nifty PE multiple then we find that the Indian share market valuation has become very expensive. Here, if we think that due to lockdown there had been a temporary fall in the earnings and after the end of the lockdown, the earnings will pace up and this PE ratio will automatically come down from 40 to 20 and the market valuation will become inexpensive, then we can be wrong here. How? Let us find out.
In the Price Earning Ratio, we divide Price by Earnings. Consider, if the PE ratio is 40 so if we divide 400 / 10, the answer comes to 40. Now, consider the earnings have increased twice. So in that case, 400 / 20 = 20. That means the PE will come down to 20 and the market valuation will become moderate. But for the market to come down to moderate valuation, the earnings have to increase two-folds. Is that possible that the earnings of the companies in Nifty increase two-folds in one year? Doesn’t look easy. Thus, as per the Nifty PE ratio too, the market valuation is expensive. In this way, before investing in the market, it is important to check the index’s price-earnings multiple.
The third important indicator for assessing the share market valuation is the Price to Book Value Ratio / PB Ratio. As per the company’s accounting, book value means the company’s value is calculated based on the comparison of its assets and liabilities as per the books. Also, the price to book value ratio is a comparison of what is the price of the share of the company. If we analyze the chart of the Nifty PB ratio, we find that whenever the PB Ratio goes above the level of 4, the market indicates moving towards higher valuation. In this manner, before investing in the market, it is important to check Nifty’s PB Ratio.
Let’s talk about the fourth important indicator which is the Dividend Yield Ratio. In simple terms, a portion of profits that the company decides to share with the investors is known as a dividend. Consider, the face value of the share which the company offers is Rs. 10/- and the company declares a dividend of 100%. This dividend is declared at face value. So dividend is equal to 10*100/100 = Rs. 10/- But when will you receive this dividend? When you own that share. Also, you won’t get the share at the face value, you will have to buy the share at the market rate. Consider, the market rate of this share is Rs. 100/- So we bought the share by paying Rs. 100 and also, we received the dividend of Rs. 10/- Due to the dividend we earned 10% returns here. That means due to dividend, we are enjoying the earnings of 10%. This is known as a dividend yield.
If we talk about Nifty’s dividend yield that means if we make a buying in the 50 companies present in Nifty then if these companies provide us dividends how much percentage of returns can we earn annually? For this purpose, if we observe the chart of Nifty 50 Dividend Yield Ratio then as per the latest data, the dividend yield which we are receiving is 1%. If we analyze the chart of Nifty Dividend Yield Ratio till date then, the dividend yield of 1% is very less and as per this ratio too, the market valuation is expensive.
In March 2020, the market established a bottom as well as the market also went into an uptrend from thereon. So if analyze the Nifty PB chart during that time then we find that the Nifty PB ratio at that time was 2.17 and the market was indicating towards being in-expensive. Similarly, if we trach the Nifty’s dividend yield ratio in March 2020 then it had reached close to 2%. Here, according to Nifty’s dividend yield chart, the market was indicating towards being in-expensive. Also, if we track the Nifty PE ratio in March 2020, it had reached around 17 – 18 indicating the market had reached a moderate valuation. Talking about the 5th indicator which is also an important economic indicator as well i.e. Debt to GDP ratio which is also an indication that the market valuation is currently expensive. The debt to GDP ratio tells us about the country’s total debt as well as the country’s total production in value. We have uploaded a detailed blog on this topic earlier, if you haven’t gone through it yet, do check it out.
India’s Debt to GDP ratio figures before corona was giving out an alarming signal. Due to corona, lockdown took place, and to get out of that situation most of the countries may resort to currency printing, and due to which the country’s debt is going to increase further from here. And if the GDP does not increase in that proportion then the Debt to GDP ratio figures will continue to indicate that the market valuation will go further higher from where it is now. For emerging markets, the threshold is 64%. India’s Debt to GDP ratio in 2019 was equal to 72% while in 2020 it was approximately equal to 90%.
So all these five indicators i.e. Market Cap to GDP Ratio, Market Price Earning Ratio, Price to Book Value Ratio, Dividend Yield Ratio & Debt to GDP Ratio are indicating that the market valuation is expensive. If we analyze the history till date when the valuations reach this stage then either the market crashes or it moves in a limited range for a long period. This time if the market challenges history by moving towards being even more expensive then that would be for a limited period. One thing is to be noted here that in the long run, the market follows the returns of the companies. And just in case if there is some unusual rise in the price than expected or a balloon is created then this will eventually burst.
Thus, invest less when the market valuation is expensive and invest only in those companies having very strong fundamentals and those that reinvest their profits in their own business and generate excellent returns. So invest in companies where growth is expected in their Top-line (profit) and bottom-line (sales) also whose debt is low. So invest here and invest less as the market valuation is expensive. And in the future, if the market crashes, you can increase your investments here and if the market goes up instead of crashing, then you will earn good returns on your investment.
On the 1st of February, the country’s budget will be presented. If we analyze the history till date then we find that before the budget is presented, the market can be highly volatile or it can also move in a limited range and what will happen after the budget? Well, nobody knows. As of now, invest less as the market valuation is expensive.
If you want to find out what is Market Cap to GDP Ratio, Market Price Earning Ratio, Price to Book Value Ratio, Dividend Yield Ratio & Debt to GDP Ratio then you can head to our app Aryaamoney. We regularly update these ratios there, so do check them out. Also, if you wish to become a successful or smart trader while keeping the market valuation in mind, also as per the market valuation in which share should you invest in, where should you place the stoploss and target, how to apply proper money management technique and trade, etc. if you wish to learn this and more then if you wish to you can subscribe to our Smart Trader Training Program in our app. Aryaamoney. Also, if you plan to invest systematically based on the market valuation then if you wish to you can also subscribe to our special service called Wealth Compounding Machine. For more information, you can reach out to us on our board line number 09922092369.
If you wish to open your Demat account with India’s leading brokers, then you can check out the link given below. We would like to give a disclaimer here that all the advice given in this blog is for educational purposes. This is not any kind of buy/sell recommendation. Mr. Bhuushan Godbole, his company as well as the director board of the company has crores of investment in the share market as well as in gold and silver. This is our disclaimer/disclosure. So we’d like to mention this again that invest in the market after thorough analysis and also after discussing it with your financial advisor.
Before investing in the market, make sure to check the market valuation using the five indicators mentioned above. So if you invest by analyzing these indicators, your journey in the market will be a smooth one.
Until next time…
Happy Trading, Happy Investing!!!
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