GDP & Growth

the percentage of total market cap relative to the GNP is “probably the best single measure of where valuations stand at any given moment.” – Warren Buffett

Is there a correlation between a country’s GDP growth and corporate profitability? From an investment perspective, it’s an important question that involves different perspectives…

Business is more stable when real GDP growth in developed countries is stable, especially when real corporate profitability is high. For example, over the past 100 years, real (inflation-adjusted) corporate profitability fluctuated between minus 5% and plus 14% when real GDP growth was between 3% and 4%.*

This question is important for both management and investors to understand the source of corporate profitability growth and how dependent profitability is on the real economy.

There is a so-called Buffett indicator, which evaluates the divergence of market capitalization from GDP and indicates how overvalued or undervalued the market is in the current period. This indicator forecasts the cumulative return of investments and its consideration is essential for making investment decisions.

https://www.gurufocus.com/stock-market-valuations.php

For example, in the United States, the correlation between corporate profitability and GDP in the long term is 2.3%. In 2007, the unprecedented 5.6% was achieved, which indicated its instability. Such profitability growth was driven mainly by two sectors – financial (due to a surge in mortgage portfolio profitability) and energy (due to rising oil prices). Then came the financial crisis, and profitability returned to equilibrium.

It is also important to understand that the price-earnings ratio (P/E ratio) in the stock market is inherently dependent on the economy – inflation and interest rate movements. The average market’s long-term P/E ratio is close to 15. However, when inflation and interest rates rise, this indicator falls accordingly.

*Source:

Value: The Four Cornerstones of Corporate Finance
by McKinsey & Company Inc.,Tim Koller, Richard Dobbs, Bill Huyett