The concept of taking data-driven investment decisions is catching the fancy of investors on Dalal Street nowadays. It’s a welcome change provided we don’t use data in an ad-hoc manner and rather follow a scientific approach.
For instance, stock market capitalization to Gross Domestic Product (GDP) ratio—or simply put, market cap-to-GDP ratio— is considered to be one of the most crucial stock market valuation indicators.
Formula of Market-cap-to-GDP ratio
Market-cap-to-GDP ratio = (Market cap of all listed companies / GDP)*100
India’s Market-cap-to-GDP ratio= (Rs 267 lakh crore / Rs 232 Lakh crore)*100 = 115%
A rule of thumb says, when the market value of the listed universe overtakes the country’s GDP, you may conclude that the market is overvalued. And the market is said to be undervalued when the ratio hovers in the range of 50%-75%.
To put it differently, a ratio between 75%-100% could be considered as an acceptable fair-value range.
At present India’s market-cap-to-GDP ratio is 115%—the highest level witnessed in the last two-decades. Now if you use this data in an ad-hoc manner, you are likely to conclude that Indian markets are extremely overvalued.
Does the situation on the valuation front look that scary at the moment?
Let’s decode the market-cap-to-GDP ratio correctly
At core, stock markets are a leading economic indicator, i.e. they generate signals in anticipation. GDP is a lagging economic indicator, on the other hand. Therefore, we shouldn’t depend solely on this ratio for determining the attractiveness of market valuations and may consider some other factors too in conjunction.
You see, market-cap-to-GDP fails to capture the market value of businesses in the unlisted space and that of the unorganized sector. In other words, it becomes extremely important to understand the level of participation the listed space has in the country’s GDP growth.
For instance, the market cap-to-GDP ratio in India was low two decades ago, not just because equity valuations were cheap but also because the unorganized sector dominated the GDP growth then. And don’t we talk about formalization of the economy and big getting bigger nowadays?
Hence, higher market-cap-to-GDP can be a function of:
And this list isn’t exhaustive.
As you may have noticed, the reasons for higher market cap-to-GDP can be multiple, sometimes overlapping and at times, contrasting.
During the pandemic, the performance of listed companies remained relatively strong as compared to that of unlisted MSME players. But the overall GDP suffered big time. Is it possible that the higher market cap-to-GDP ratio is a reflection of that?
Consider this aspect as well
The Primary market has remained a popular fund raising avenue for Indian corporates.
In the first 9 months of FY22, Indian companies have mopped up over Rs 1 lakh crore in the primary market. Some startups have witnessed dream listings. With the likes of LIC waiting in the wings, the market capitalization of Indian bourses is likely augment further.
More companies getting listed on bourses can affect the market cap curve positively.
The corporate earnings growth momentum is expected to catch up over the next few quarters and, as a result, market valuations have remained elevated. Easy liquidity further facilitated the rise in the market cap of the listed space.
Thus, you should use the market cap-to-GDP ratio in conjunction with other valuation indicators, such as Price-to-Earnings (P/E) multiples and corporate profits-to-GDP ratio, to name a few.
We have made another interesting observation which is very crucial in the context of today’s topic.
The market cap under T group and Z group stocks is at a multi-year high at present.
As you might know, T group shares are settled on a trade-to-trade basis. You can’t settle these trades before you get their delivery—so, no intraday or buy-today-sell-tomorrow (BTST) trades. Such grouping indicates that these shares are under surveillance.
Listing-related compliance failure lands stocks in the Z group.
The average market cap of T group and Z group shares has been 1.2% of the total market cap of companies listed on BSE for the last two decades. At present, the contribution of T group and Z group companies collectively stands at 2.5%. This may still look tiny but in absolute terms it’s considerably high as compared to the tally of the past few years.
The dominance of A group stocks in the market cap composition of India has grown steadily throughout the last two decades, thereby suggesting us the way to go.
The key takeaways are
It’s time to stay away from speculation and stick to counters where the earnings expectations and delivery of performance are in sync.
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