BT Insight: Are Sensex, Nifty overvalued? Here's what metrics show

The stock market is hot and running. The benchmark Sensex hit its all-time high of 44,825.37 last week, while Nifty crossed 13,000 for the first time. However, the stock market is not really reflecting the true picture of how businesses are doing. "I don't know why the market levels are where they are right now, when the economy is in the mess. It's the same globally. But I have not seen it in my 35 years of career," says Nithin Kamath, Founder & CEO at Zerodha.

The GDP growth fell to 7.5 per cent in the July-September quarter compared to a contraction of 23.9 per cent in the April-June quarter. The contraction in Q2 may have been slower, but the economy has slipped into a technical recession. The markets will react to the news on Tuesday. Meanwhile, investors would do well to read into various valuation metrics to gauge the market direction.

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Price/earnings (PE) ratio

The most popular valuation metric is studied in two forms -- the trailing PE ratio and the forward PE ratio. The Nifty 12-month trailing PE quoted 35.71 on November 26 compared to its long-period average of 19.8x. A range between 25-30x is considered highly overvalued.

As for Nifty one-year forward P/E, it is trading around 22.6, says Deepak Jasani- Head of Retail Research at HDFC Securities. This is higher than the 10-year average of 18.5. The higher the value above the long-term average, the more overpriced the index becomes. However, Jasani says the average PE of last five years is 21.1. He believes the PE band requires revision in terms of valuation indicator.

"The levels of P/Es have been lifted over the past few years driven by rising liquidity and falling interest rates. So even though the current P/E seems higher than the 10-year average, it is not far from the five-year average," he says.

CAPE ratio

With substantial blip in corporate earnings in the last two quarters due to COVID-19, experts say the PE ratio may not be a correct metric to judge the market valuation. They say Cyclically Adjusted PE Ratio (CAPE) that takes into account average earnings of last five to 10 years may give a better picture.

Introduced by Nobel laureate Robert Shiller, CAPE is also called Shiller PE ratio. But even this metric is showing overvaluation. "Market is expensive as per our CAPE model for the Nifty. At ~26x the market is above 1 standard deviation (s.d.)and that is a clear sign of overvaluation. CAPE closer to the long-term average would indicate fair valuations while closer or below -1 s.d. would indicate extreme undervaluation as was seen during the market crash of 2008 and during the Taper tantrum period of 2013," says Vinod Karki, Head - Strategy, ICICI Securities.

Market cap-to-GDP ratio

Market cap-to-GDP ratio, also called the Warren Buffett indicator, has been volatile as it moved from 79 per cent in FY19 to 56 per cent (FY20 GDP) in March 2020 to 80 per cent now (FY21E GDP) - above its long-term average of 75 per cent, says Motilal Oswal Securities. The market is considered in the bull market if the Warren Buffett indicator moves in the range of 70-80 per cent and above.

BEER ratio

Bond Equity Earning Yield (BEER) ratio compares 10-year government security yield with the earning yield of the stocks or a stock index. A BEER ratio of 1 means that both equity and bond market have equal level of perceived riskiness (or both equity and bond markets are fairly valued). BEER ratio greater than 1 means that equity market is overvalued, while BEER ratio smaller than 1 means that equity market is undervalued.

According to Jasani of HDFC Securities, the current BEER ratio is 1.33 based on one-year forward earnings yield.    "The historical range of BEER ratio in India has been between 1.5 and 0.8. Based on this band, there is scope for either the 10-year Gsec rate to move up or earnings yield to fall (and hence P/E ratios to rise)," says Jasani.

Other valuation metrics that one may look into include PEG (price/earnings to growth) and price-to-book ratio. While PEG ratio depicts today's earnings and the expected growth rate, P/B ratio shows the difference between the market value of a company's stock and its book value.

What should you do?

It's time for caution. If you have to make fresh investments, you should not invest all your surplus money in one go. Take staggered approach to investment. If you are already invested, you must figure when to book profits.

"Your decision to book profits will depend on your financial objectives and asset allocation. If you invest in equities for the long term, the option of profit booking arises only for two reasons; first, if you are approaching a long-term goal for which the investment needs are to be utilised, and secondly, to rebalance your asset allocation. Therefore, the right time to book profits is when you come under such circumstances otherwise you should not book profits simply because everyone is selling or the market is at its peak," says Palka Chopra, Senior Vice President at Master Capital Services.

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