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Last Updated : May 22, 2012 08:34 AM IST | Source: equitymaster.com

Warren Buffett`s best metric for market valuation

Legendary investor Warren Buffett calls this ratio as "probably the best single measure of where valuations stand at any given moment". His disdain for macroeconomics is legendary.


Legendary investor Warren Buffett calls this ratio as "probably the best single measure of where valuations stand at any given moment". His disdain for macroeconomics is legendary. But even he is willing to relax his otherwise strict stance on macroeconomics just for this one ratio that has a country's GNP (Gross National Product) as one of its key components. The ratio is nothing but the total market cap of all the companies listed in an economy to that economy's GNP. Over the years, this ratio has done a very good job of determining long-term returns that an investor can expect from the stock markets.


Infact, in an article that appeared in the popular magazine, Fortune, somewhere at the turn of the century, Warren Buffett had used this ratio extensively. He used the ratio to arrive at the conclusion that despite a steep fall in the US markets in the aftermath of the tech bubble, US stock markets were far from being cheap and over the next decade or two, investors would be making a mistake if they expect stock market returns to exceed the 7%-8% range.
Today, more than seven years after he wrote the article, S&P 500, one of the major US stock market indices is actually down 27%, a negative CAGR of 4%. Hence, for his 7%-8% returns theory to come good, US stock markets will have to actually rise more than 7%-8% over the next few years. And there are good chances that these returns could be achieved. We say so because just a few months back, when Fortune calculated the market cap to GNP ratio, it stood at a reasonable 70%-80%. To put things in perspective, at its peak in March 2000, the ratio stood at a mindboggling 200%, prompting Buffett to significantly downgrade the returns that investors were expecting from stock markets over the next decade or two.


The numbers mentioned above could have surely created a few doubts in our mind. Allow us to clear them. A country's GNP could be thought of as revenues of one big business and the country's market cap nothing but the value that investors are willing to assign to that business. Over time, everything else remaining constant, both the market cap as well as GNP should grow at a similar rate. But that is not the case. At times, market cap grows at a faster rate than GNP but it cannot continue doing so for ever. Thus, when the ratio becomes unsustainable or unrealistic, market cap falls adjusting to the new reality. As per Buffett, if the ratio is in the region of 70% - 80%, buying stocks are likely to work well over a long-term period. Of course, this is not to say that the ratio cannot go lower but we believe that one should start buying stocks if the ratio achieves the above mentioned threshold and keep buying if it falls further.


Picking up on this theme, one of the popular value-investing websites has actually come out with a table that lays out the various scenarios for the ratio and what do they effectively mean for the overall market valuation as a whole.




 


 


 


 


 


 


As can be seen, the range that Buffett talked about i.e. the 70%-80% range indicates that the markets are somewhere between moderate valuation and fair valuation. If the ratio exceeds 115% as it did in late 1990s and most of this decade, the markets are in the overvalued zone where odds of investing are not in the favor of investor from a long-term perspective.




 


 


 


 


 


 


 


 


 


Source: Ace Equity, Government of India


Assuming that a similar approach works in India as well, where do we stand currently and how has been our historical performance? The chart shown above could give us some idea. As can be seen, the ratio came within striking distance of touching the significantly overvaluation zone somewhere in 2007-08 and the market has significantly pulled back since then. Assuming an advanced estimate of GNP by the Government of India, the ratio currently stands at 66% (BSE 500  market cap/GNP), indicating that the markets could be in the moderately undervalued zone. Thus, from a long term perspective, markets are definitely looking attractive.


The fact that the ratio has gone as low as 31% few years back does make even the current levels look expensive. However, it should be noted that Indian economy seems to have moved to a higher growth trajectory of the order of 7%-8% and hence, there is very little chance that market cap to GNP ratio of 30% will ever be seen again.


Thus, taking all of this into account, it may not be a bad idea to start building exposure to equities with a long term horizon in mind.

Equitymaster.com is India`s leading independent equity research initiative



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First Published on May 21, 2012 05:15 pm
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