5 Tips To Know if The Market is Overvalued!

5 Tips To Know if The Market is Overvalued!

Tips to know if the market is overvalued: From June 2020 to October 2021, the Indian stock market has grown tremendously. These 17 months have generated a total index return of 112% (NIFTY) and 106% (SENSEX), which is the biggest bull run in the stock market. 

Most investors always believe the market is fairly valued and buy-in and when the market is at its high, eventually the stock price falls, and nobody is happy with that. 

These over-the-top returns make us question if the stock market is overvalued or not. Well, there are certain indicators that show if the market is overvalued or not. 

Here are five tips to know if the market is overvalued or not –

1. Market P/E Ratio 

The P/E ratio is a very common valuation ratio used in the valuation of stocks. The formula goes by market share price over earnings per share. A higher P/E ratio compared to the industry average for the company means the company may be overvalued. 

The mentioned way was to calculate for a company, we need to calculate for the whole index. The essence of the formula remains the same. 

There is a measure to calculate the whole index, and this is used for checking if the market is overvalued or not. 

The formula for the market P/E ratio = Total Market Capitalisation of the Index / Earnings of all companies in the index combined 

In this, we are going to check the P/E of the NIFTY. The average P/E ratio of the NIFTY is 20. 

The current P/E ratio as of (11/03/2022) is 21.34, which indicates that the market is not overvalued and is around average. 

The P/E ratio in March 2021 was 41, which was very high. 

If the market P/E is somewhere close to 12 to 15, that’s a great sign to invest in fundamentally good stocks.

Source: Reddit-Indian Stock Market. 

This is a NIFTY P/E Ratio heat map for better presentation. The higher the P/E, the darker the color. Know about the different financial ratios that every investor should know.

2. Shiller P/E Ratio 

The problem with the index P/E ratio is that it can be highly impacted by economic cycles, so Yale professor Robert Shiller proposed a formula to determine if the market is undervalued or overvalued. It is also known as the CAPE ratio (cyclically adjusted price to earnings ratio). 

He proposed including the average earnings of 10 years, which are then adjusted for inflation, giving a more accurate data set. This helps in smoothing the volatility in the short-term and gives an idea of the long-term. 

The formula for Shiller’s P/E ratio = Total Market Cap / 10-year average inflation-adjusted earnings 

In December 2021, the Shiller P/E ratio of NIFTY was 34.77, whereas the 20-year average is 25.9. 

NIFTY’s Shiller P/E ratio is way above average.

3. Market Dividend Yield 

We all know that dividend yield is a financial ratio that measures how much cash is paid out to the customers relative to the market value of the share. A dividend acts as a passive income to the shareholders, making it attractive to hold the stocks for the long term. A stable and rising dividend yield is a very good sign of the company’s performance in the long term. 

A high dividend yield indicates the market is undervalued, and a lower dividend yield indicates the market is overvalued. 

A good market dividend yield ranges between 1 and 2 and the average dividend yield of the NIFTY is 1.41. 

In March 2021, the market dividend yield was 0.96, which is less than 1, making the market overvalued. 

The current dividend yield as of March 2022 is 1.26, which puts it in the overvalued zone.

ALSO READ: Five Tips For Stock Market Beginners!

4. The Buffet Indicator 

The Buffet indicator was introduced by billionaire investor Warren Buffet. According to Warren Buffet, if the market capitalization is more than the GDP, then the market is overvalued.

The Buffet indicator formula = Market Capitalisation of the country / GDP of the country 

India’s average market cap to GDP is 75%, and if it is more than 100%, it is said to be overvalued. 

In June 2021, it was 115%, and the latest data is from February 2022, when it was 116%, indicating it is in the overvalued zone. 

The simple calculation would go like this. 

Indian Stock market cap = 3.4 trillion Dollars , Indian GDP= 3.25 trillion Dollars 3.4/3.25 = 1.046 this multiplied by 100 will 104.6% 

5. Bond Equity Earnings Ratio (BEER) 

Bond markets have a ripple effect on the economy. If the bond yield rises, the price of the stocks goes down. This is because bonds are considered safer than equity returns. This ratio can estimate the direction of the stock market too. The following BEER formula is one of the important tips to know if the market is overvalued.

BEER Formula = 10-year government bond yield / Stock market earnings yield 

If the bond earnings yield ratio is greater than 1, the market is said to be overvalued. The market’s earnings yield is the reversal of the P/E ratio. (reciprocal) 

Current BEER of Indian stock market using the NIFTY index. 

The current government 10-year bond yield is 6.855% and the current earnings yield is 4.68% (11/03/22). 

The calculation would go like this: 6.855% divided by 4.68% = 1.46. It is more than one, which indicates the market is overvalued. 

Investing in an overvalued stock market is quite scary, especially when there are macroeconomic problems. What we can do is to have a disciplined style of investing and aim for the long term. Overvaluations are a temporary thing. 

The best thing is to have a mixture of different assets that protect us from these shortfalls. That’s all for the article on tips to know if the market is overvalued.

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