Is the market overvalued? Track these 3 parameters to gauge valuations

Tracking valuations through the lens of these three parameters will help you make better calls in the market

July 03, 2021 / 11:30 AM IST

The question on everyone's mind today is are the markets overheated? The big disconnect between main street and Dalal street is a hot topic on various online forums and is trending on the investing rooms of the Clubhouse app as well.

While the bulls of not only Dalal Street but also of Wall Street keep talking about how their party is just getting started and we are on the cusp of a multi-year bull run. The bears flash warning signs that capitulation is just around the corner.

As a neutral stock market observer, who has always believed that the 'trend is my friend', I give a patient hearing to both camps and don't disagree with either. After all, being a sales guy, I've also been taught that the first rule of sales is always agree.

That said, as an investor who has blown his trading account on a few occasions in the past, I do believe that keeping an eye on certain indicators is always good. It was in the autumn of 2018 that I attended a value investing workshop in Bangalore. This was licensed by Mary Buffet, who is Warren Buffet's former daughter-in-law and of course covered a lot of his philosophy of value investing. Mary, while she was married to Peter had an active interest in investing and decided to start courses with licensees around the world.

Let’s apply some of these investing principles to the Indian market. Again just a disclaimer this is just my opinion and I'm not a SEBI registered investment adviser, so do check with your financial planner before doing anything in the markets.

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Stock Market to GDP Ratio

So let's first take a look at the 'Stock Market to GDP Ratio'; this ratio is sometimes referred to as the Buffet indicator. It is a good way to check if the market is overvalued or undervalued compared to its past historical average.

If the indicator reads below 75, I feel there is tremendous value in the market and it's undervalued. Normally, a number between 75 and 90 scores as fair, while 90 and above could indicate signs of being overvalued.

As recently, as on June 4, 2021, the Indian markets hit a number of 115 percent, the highest since 2008. Subsequently, the number has cooled a little, and as of today, this number stands at 104. I did pull that number on an online site but I do think that would be relatively accurate. Do check once at your end as well. This ratio is calculated by dividing the total stock market capitalisation by the gross domestic product of the country and multiplying it by 100. So an easy calculation to do at your end. It's not a commonly used indicator by many investors but always good to keep an eye on.

While the above ratio is for gauging the stock market as a whole, let's take a look at two ratios that you can look at for individual stocks.

Price to Book Value per share

The calculation of price to book value per share is quite simple and all you need is access to the company's current share price and their latest balance sheet.

The price to book value is calculated by dividing the current price of the share by the book value per share. In case you want to calculate the book value per share, you do that by dividing the book value by the number of shares floating in the market.

Traditionally, a good price to book value in a market used to be 3 and below. Today, you'll probably find it hard to find a share with that number, taking an example of Tesla in the US, which is probably a little above 25, Facebook may be trading with a number closer to 10.

Now, this variable also has some limitations and many experts will tell you that this has to be seen in conjunction with many other factors before deciding your strategy.

P/E Ratio

The last ratio I want to write about is the Price-to-Earnings ratio or the P/E Ratio. As a new investor in the market several decades ago, I was always told to keep an eye on this number and was often told that anything more than 10 is expensive. Subsequently, with the technology companies coming in and ruling the roost, 10 just seems like a woefully conservative number. That said, let's look at how to calculate this number as well, it will be calculated by taking the current share price and dividing it by the EPS or earnings per share.

Again, taking an example of some global companies, Facebook currently has a PE ratio of 29 and Tesla has one of 624! I usually do still look at the PE ratio of a stock and compare that with the PE ratio of the Nifty. The Nifty PE ratio was up over 40 till just two months ago and has now cooled down to below 30. Still high, some would say but on the flip side, a post-pandemic consumption boom in India could change everything.

Disclaimer: The views and investment tips expressed by investment expert on Moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.
Gaurav Bhagat is the Founder of Academy.
first published: Jul 3, 2021 11:30 am

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