Sensex is at 28,500 is it too high? Gold is at 2,700 can I buy at this price? These questions are looking at just one number and trying to determine if it is reasonable. This is almost like looking at a cab fare and not considering the distance you want to travel.
Sensex is a measure of market value based on 1979 as a reference year where it was pegged to 100. But the value of Sensex does not tell us anything about the valuation. To understand if the markets are undervalued or overvalued one should look at the relative indicators. Let’s look at a few examples.
P/E – This indicates the price we are paying for every unit of earnings. This ratio can be compared with its historical data (and also with other economies) to make a determination about the overall valuations. Current P/E is 18.52 vs historical median of 18.4. If the earnings improve and price levels remain the same then this becomes an attractive investment opportunity. If the prices raise with earnings staying the same or deteriorating then this is not an attractive proposition.
Another ratio we can look at is market capitalization to GDP. Market capitalization is the value of all the listed companies. GDP is the value of the national output for that year. This ratio gives the percentage of GDP that represents stock market value. Typically, a result of greater than 100% is said to show that the market is overvalued. This ratio for India is currently 70% which means that overall valuations for the country are ok.
Another ratio is financial wealth to nonfinancial wealth. As countries develop more and more of their wealth is represented by financial wealth. This ratio for India is 14% as compared to a world average of 131%, this means that valuations have a significant upside.
Based on P/E we can say the current market levels in India may not have significant upside, whereas Market capitalization to GDP ratio and ratio of financial wealth to nonfinancial wealth indicate that there is significant upside potential. Corrections in P/E can happen quickly but changes in the other two ratios take much longer. In summary, investments in financial assets (equities) in India will make sense for people who have long investment horizon.