The Buffet Indicator is a measure of the total value of all publicly-traded stocks in a country divided by that country’s GDP. It’s a measure and ratio to evaluate whether a market is undervalued or overvalued. It’s one of Warren Buffet‘s favorite measures as a warning that financial markets might be overvalued and riskier.

Understanding the Buffet Indicator

Developed by billionaire investor Warren Buffet, the indicator is a broad measure of whether a given stock market is overvalued or undervalued. It rose to prominence after Buffett once noted that it was “probably the best single measure of where valuations stand at any given moment.”

In the United States, most experts use The Wilshire 5000 Total Market Index which represents the value of all stocks in all U.S. markets. At the end of June 2020, the U.S. stock market was valued at approximately $35.5 trillion. Estimated GDP at this time was $19.41 trillion.

Therefore, the market value to GDP ratio is calculated by dividing 35.5 by 19.41 and then multiplying by 100 to express the value as a percentage. In this case, the Buffet Indicator is 182.9%.

Interpreting Buffet Indicator values

Broadly speaking, Buffet Indicator values describe stock markets that are:

• Undervalued near 50%.
• Modestly undervalued in the range of 50-75%.
• Fairly valued in the range of 75-90%.
• Modestly overvalued in the range of 90-115%.
• Overvalued above 115%.

Returning to the example in the previous section, we see that the U.S. stock market is currently overvalued. However, there has been much conjecture over whether this stock market is overvalued given its sustained increase in value over recent decades.

Implications of the Buffet Indicator for investors

When the total market value of a stock market is less than GDP, investors see an opportunity to buy. Conversely, when the total market value is worth more than GDP, investors are more wary and likely to sell.

Corrections in overvalued markets – where investors sell en masse – have also historically preceded recessions. The dotcom crash of 2000 and the global financial crisis of 2008 are two such examples of the Buffet Indicator correctly predicting a correction and subsequent stock market devaluation.

Potential flaws of the Buffet Indicator

The Buffet Indicator has some potential flaws, including:

• Misleading data. While the Buffet Indicator is a great broadscale metric, this can make its calculations relatively crude. In other words, the indicator does not take into account the profitability of a business – only its revenue.
• Lack of flexibility. As previously mentioned, the Buffet Indicator is perhaps less useful in positively trending markets such as in the U.S. that has enjoyed a sustained increase in value. The blanket categorization of 100% equating to an overvalued market may no longer be relevant as baseline levels of valuation shift.
• Lack of scope. Since the Buffet Indicator only tracks publicly listed companies, it does not take into account private companies when assessing whether a market is over or undervalued according to GDP.

Key takeaways

• The Buffet Indicator is the ratio of total stock market valuation to GDP, most commonly associated with the US stock market.
• The Buffet Indicator gives the degree of over or undervaluation according to the exact percentage value obtained.
• The Buffet Indicator has several disadvantages owing to a lack of scope and flexibility in calculating its values.

Connected resources:

• Financial Ratios
• Financial Statements
• Balance Sheet
• Gross Margins
• Moat

Additional resources:

• Business Models
• Business Strategy
• Digital Business Models
• Distribution Channels
• Go-To-Market Strategy
• Marketing Strategy
• Network Effects
• Platform Business Models
• Revenue Models

The post What Is The Buffet Indicator And Why It Matters In business appeared first on FourWeekMBA.