P/E and market cap-to-GDP ratios can be excellent indicators that you can rely on while investing in equities.
Investors can use the price-to-earnings (P/E), and the market cap-to-GDP to make sense of market valuations. The market or index P/E ratio helps investors to determine whether it’s the right time to invest or exit. The market cap-to-GDP ratio allows investors to assess market valuations against the GDP.
How ratios help investors to make investment decisions
Looking at market levels alone can be misleading. Investors may conclude after a big fall that it is a good time to invest. However, the index P/E ratio will reveal the real picture. If the index P/E ratio is high, fresh investments will not deliver good returns in the following years.
In the same way, a low market cap-to-GDP ratio shows that valuations are reasonable. This could be the case even if the index P/E ratio is quite high. It’s best to study different ratios before making up your mind about market valuations. A simple buy-and-hold strategy can also help you to avoid timing errors.
You can also consider the price-to-book value ratio (P/B ratio) and dividend yield. If the index P/E ratio shows a certain valuation picture, you can look at other ratios confirm this. Other indicators may reveal a different picture.
Trailing P/E ratio vs. forward P/E ratio
Investors use two variants of the P/E ratio to assess valuations. The trailing P/E ratio uses the earnings of the last 12 months. The forward P/E ratio uses the projected earnings for the next 12 months. The trailing P/E ratio is much more reliable. It uses historical data that everyone can access.
In comparison, the forward P/E ratio uses estimates of future earnings. They use data that is not available to everyone. These estimates are often flawed or biased. As a result, the forward PE ratio is not as reliable.
That’s why it makes sense to track the trailing P/E ratio to assess market valuations. This may be the most accurate way of determining whether the market is at an attractive level or not.
Also read: Financial Ratios Analysis for Investors
How to use the P/E ratio to make investment decisions
The price-to-earnings ratio or P/E ratio is one of the most important valuation tools. It is very easy to use and helps investors to assess valuations. When the index P/E ratio is low, valuations are cheap. Investments made at such times usually generate high returns in the following period.
P/E ratio = market price per share/earnings per share (EPS)
The Nifty P/E ratio is the average P/E ratio of the Nifty 50 companies. The Nifty P/E ratio is expensive when it is around or more than 22. It is oversold when it is less than 14. If the Nifty P/E ratio is around 26, as it is now, it shows that the Nifty is at 26 times its earnings.
In January 2008, the Nifty P/E ratio peaked at around 28. This meant that the market was very expensive. By October 2008, the Nifty P/E ratio had fallen to around 12. This showed that the market was very cheap. If you had invested at that time, you would have made spectacular gains.Learn how to mange your money & create wealth, Download your FREE eBook now
Limitations to using the P/E ratio to assess valuations
You may miss out if you wait to invest at a time when the index P/E ratio is low. The market may keep raising without any indication. You may end up missing the rally. If you invest when the index P/E ratio is low, the market may fall further and may not rise for a long time.
If you sell when the index P/E ratio is high, the market may rise further. It may continue to go up for a long time and you may miss out on the gains.
It’s never easy to time the markets. Those who attempt to do it often miss out on returns because of timing errors. This happens even with experienced fund managers.
Besides, the P/E ratio only accounts for the total earnings of all the listed companies. It doesn’t consider unlisted businesses and companies and government-owned companies. This is where the market cap-to-GDP ratio helps investors.
How to use the market cap-to-GDP ratio
The market cap-to-GDP ratio provides a different viewpoint. It gives investors a more complete picture of valuations as compared to the economy.
Market cap-to-GDP ratio = the market capitalization of listed shares / annual real GDP
If the market cap-to-GDP ratio is less than 100%, stock market valuations may not be expensive. If it is higher than 100%, it indicates the stock market valuations may be expensive.
In 2017, India’s market cap-to-GDP ratio had crossed 100%. This happened after a gap of almost 10 years. It showed that the markets may have been expensive. In 2018, the market cap-to-GDP ratio has fallen to around 88%. This shows that India’s market valuations may not be expensive. This is despite the very high P/E ratio.
Limitations to using the market cap-to-GDP ratio
Using the market cap-to-GDP ratio to assess valuations has its drawbacks. It’s more useful if the stock markets represent a big part of the country’s economic activity.
Indian stock markets don’t represent a big part of the national economy. However, the market cap-to-GDP ratio is rising. More and more sectors are brought into the realm of the capital markets.
In advanced countries like the USA and the UK, a large part of the economic activity is in the formal sector. As a result, the market cap-to-GDP ratio is much higher than 100%.
Another problem is that the numerator and denominator represent different things. They are not comparable. This means that the market cap-to-GDP ratio does not provide precise figures.
Investors cannot assess valuations by tracking market levels alone. The trailing P/E ratio helps investors to evaluate market valuations. It allows investors to decide about whether it’s the right time to invest or exit. The market cap-to-GDP ratio looks at market valuations against the GDP. Other metrics like the P/B ratio and dividend yield also provide valuable insights. Together they can help you to make the right investment decisions.