market valuation

How To Find If Market Is Overvalued? Use These Two Easy Methods

July 11, 2018 2 Ankit Shrivastav

Introduction:

Most investors willing to invest for long term in the market have a very common question in mind such as: Is it the right time to enter? Will the market rally from here or go down? Is it the right time to create a fresh portfolio for long term?

You too might have these questions in mind. Most investors find timing the market very puzzling and difficult.

This is the reason why they remain on the sidelines watching the ups and downs of the market, instead of participating in it.

What if I tell you that there are two pretty accurate ways to assess market valuation? using these, you can figure out whether to get in or get out of the market. Wouldn’t that be great?

That is exactly what we are going to discuss. The two methods widely used by analysts and investors alike to understand market valuations are:

Nifty P/E Ratio and

Market Capitalization to GDP Ratio.

Market Valuation

What is Nifty P/E?

Before we understand how to use Nifty P/E for our analysis, it is important to understand what is Nifty P/E.

Nifty is a market index, composed of top 50 stocks. Every company has a P/E ratio which shows the relation between price and earning of the company.

For example, if a company is trading at a P/E of 10, it means investors are willing to pay Rs. 10 against each rupee earned by the company.

If a company is trading at a higher P/E , it implies that investors are willing to pay higher price for the same earnings, making it an unattractive investment.

In case of Nifty, the Nifty P/E indicates the average P/E of all the companies composing Nifty index.

So if Nifty is trading at a high P/E Ratio, it means that investors are willing to pay higher price for each rupee earned by Nifty 50 companies, making it expensive.

How to use Nifty P/E as a valuation indicator?

So how can Nifty P/E be used as  market valuation indicator? By looking at past historical records and trends of Nifty P/E

If we look at the last 20 years of historical P/E of Nifty, we find a pattern that can be used to predict whether the market is overvalued or undervalued. Here is the chart of last 20 years of Nifty P/E from a website https://nifty-pe-ratio.com/

Nifty P/E

As you can see from the image above, every time Nifty P/E went above 25 or 27.5, there market became overbought and there was a correction after sometime.

In the past 20 years, Nifty P/E has touched these levels twice, first in Feb 2000 when Nifty was trading at a P/E of 27.82 and second in January 2008 when Nifty P/E was trading at a P/E of 27.7.

On the lower side, the bottom (also called oversold levels) of the Nifty can be found at around P/E of 12 a point from where markets rebound. In the past 20 years Nifty has touched these levels twice, on in May 2003 when Nifty was trading at a P/E of 10.86 and other in October 2008, when Nifty P/E was trading at a P/E of 10.99.

Looking at the past 20 years of trend, we can say that every time Nifty P/E goes above 27, its a strong indicator of markets being overvalued and investors must be careful expecting a correction.

On the other side, if the Nifty P/E is trading below 12, we can assume that market is undervalued and it is a good time to start investing in stocks with a long term investment horizon.  

At the time of writing this post, the market is trading at a P/E of 26.62, which is close to the overvalued territory and a correction may take place in the near future.

A word of caution…

Although Nifty P/E is a very useful ratio to measure the market valuation, it has its own drawbacks. Since Nifty is composed of top 50 stocks only, Nifty P/E represents the valuation of top 50 companies and not the entire market.

Thus, even when Nifty is trading at high valuations, there can be many companies outside Nifty 50 stocks, that are available at attractive valuations, providing a great investment opportunity.

That is why, the valuation of Nifty P/E is relevant for those investors willing to invest in Nifty companies and does not necessarily represent the valuation of the entire market.

The second valuation method we are going to discuss is more accurate and covers the entire market, giving investors a complete picture of the market valuation. This valuation method is Market Capitalization to GDP ratio.

Market Valuation

Market Capitalization to GDP Ratio:

Market Capitalization to GDP ratio is more accurate measure of market valuation. It is one of the most favourite valuation ratios of Billionaire investor Warren Buffett.

In this ratio, the market value of all the listed companies is divided by the country’s GDP.

The idea behind this ratio is simple. Stock prices are derived from expected earnings for corporates and GDP represents revenue of the country. This gives investors an estimate of whether the two are moving in tandem.

In other words, the price of a stock is determined by the earnings of the company, and total earning of all the corporates form the total GDP of the country.

If the market Capitalization of all the companies is equal or higher than country’s GDP, it means that market have priced in all the corporate growth in its earnings and now there is no more upside left.

On the other hand if the total Market Capitalization of all the companies is lower than the GDP of the country, it means that all the earnings of the companies has not been priced in and there is still some upside potential left in the market.

How to determine market valuation using Mcap to GDP ratio:

There is a broad range of this ratio within which it fluctuates, any breakout on either side indicates overvaluation or undervaluation of stock. Just like Nifty P/E ratio, we will use historical data to determine the true valuation range of the market to understand whether it is overvalued or undervalued.

market Valuation

In the image above we have taken past 7 years of Market capitalization to GDP data from www.equitymaster.com. It can be seen from the image above that when the market capitalization of all listed companies is close to 50% of GDP, the market is considered as undervalued.

On the other hand, when the market capitalization of all the companies is close or above 100% of the GDP. the market is considered to be overvalued.

At the time of writing this article, the market capitalization of all the companies is almost 97% of the GDP.

Conclusion:

Market valuation can play a crucial role for investors to make right investment decisions.

Investors who track the market valuations and make buying and selling decisions accordingly have a good chance of beating the market in term of return on investment.

Both Nifty P/E ratio and Market capitalization to GDP Ratio are really useful, but as mentioned earlier, market capitalization to GDP ratio is comparatively more accurate measure of valuation.

I hope you find this article useful and you will use these strategies to make the right investment decisions.

Total Comments ( 2 )

  1. Jaimin says:

    I have a question:
    The market cap is applicable for only listed companies while the GDP considers all the output form the country. Also time to time, new companies are added to the exchanges, so that adds up to the Market Cap but not to GDP.

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