Relative valuation techniques for nations?

After recently wrapping up a class on Financial Information Analysis that I took this Spring, I began to wonder whether the valuation techniques used to value financial assets could be applied in a broader setting, perhaps to value entire national markets. To begin answering this question, I decided to pick two countries that I am most familiar with and compare some broad economic attributes.

With the current weakness in the U.S. dollar and the corresponding strengthening of the Indian rupee, the total market capitalization of all stocks listed on the Indian capital markets crossed the 1 trillion dollar mark for the first time. Coincidentally, the country's GDP also exceeded the 1 trillion dollar level at about the same time. With this rise, India is now one of the top 12 nations in the world with aggregate annual national income greater than 1 trillion dollars.

In the valuation world, P/S is a popular ratio which expresses the price of an equity asset as a multiple of the sales of the firm. This is similar to the even more popular P/E ratio which compares the price of the stock with the earnings of the company. P/S is particularly popular in M&A transactions and most commonly used in situations where the target company has negative earnings. The P/S ratio for the Indian markets is 1 because both the total market capitalization (equivalent to the price of the stock) and the GDP of the country (equivalent to the sales of a company) are approximately $1 trillion.

Now, let's do the numbers for the Unites States. The total market cap of all public companies traded on American exchanges is somewhere in the 27-28 trillion dollar range. The GDP number for the U.S. as of 2006 stood at $13.24 trillion. So, P/S for the U.S. is roughly 2, twice that of India.

Similarly, the ratio for China is a little more than 1.

The P/S ratio itself has a lot of flaws. It is an inconsistent ratio because it compares the price an equity investor is willing to pay with the sales of the company which all stakeholders including lenders (not just equity holders) have a claim on. Applying this to countries may be even more flawed, but it is an interesting exercise nevertheless.

Taking this one step further is even more interesting. When we factor in growth, it is easy to see that the PEG ratio (which measures the PE multiple investors are willing to pay per unit of growth) for the U.S. is 2/3 or 0.667 and the ratio for India is about 1/9 or 0.11. From valuing stocks, we know that lower the PEG ratio the more attractive the stock, all other things being equal.

These quick calculations seem to suggest that the U.S. markets are over-valued compared to the markets in China and India. Time to short the U.S. markets and go long in India and China?

Interesting fact: The total global market capitalization was $51.225 trillion in March 2007.