MCap ÷ GDP Ratio — How useful is this metric ?
One of the often quoted metrics to assess attractiveness of equity markets is the Market Capitalization to GDP ratio (MCap ÷ GDP). This indicator was popularized by Warren Buffet as a temperature check on the market, a lower number is considered attractive from a risk-reward standpoint, and a higher number relative to prior years indicates that markets are probably over-valued. Of late, this metric has been fluctuating widely given the volatility in equity markets and underlying GDP projections.
This got me thinking about the usefulness of this metric in the current day and age, given the shift in consumption patterns and evolving business models of companies.
Consider the case of US Big-Tech companies. Given their near dominant market share across multiple industries (Amazon in e-commerce, Google and Facebook in advertising, Apple in smartphones, Netflix in OTT, etc.), the market capitalization reflects the competitive advantage and cash generation capability of these companies across the globe. The US GDP can only partly benefit from the leadership position of these companies outside US, to the extent that USA is a part of the global supply-chain. Hence, the market capitalization captures the benefit accruing to these businesses across the globe, while GDP does so to to the extent the of associated activity and value-add within USA. In such a case, a relatively higher MCap ÷ GDP (say for NASDAQ) is not necessarily an indicator of an over-valued market.
At the other end of the spectrum, the new-age businesses in India such as Byju’s, PayTM, Oyo, Ola, etc. have significantly transformed consumption and spending patterns, and in the process these companies have reached astronomic levels of valuations. While the underlying activity on these platforms does contribute to the GDP in a meaningful way, their valuation is not captured in the market-cap, given these companies are still private. Another dimension to this is the market share of global companies such as Amazon in Indian economy, contributing to GDP but again not captured in market-cap.
With changing business models and global leadership positions of companies, the MCap ÷GDP ratio cannot be readily used as a barometer of risk-reward in equity markets. The global shift to digital medium across commerce, entertainment, advertising, etc. is likely to get reflected in the valuations of US technology companies, as a result the MCap ÷ GDP ratio for indices such as NASDAQ is likely to inch higher over time.
