Index-based valuation is tricky

Changes to the benchmark Nifty 50 index will be effective from 28 March. Jio Financial Services Ltd and Zomato Ltd will replace Bharat Petroleum Corp. Ltd (BPCL) and Britannia Industries Ltd.

- Manish Joshi

The reshuffle will alter the index's price-to-earnings (P/E) multiple and revive the debate over whether Nifty's valuation is expensive or justified—particularly among fund managers who rely on index-based valuations for capital allocation to countries.

But how useful is index-based valuation? To answer that, it is essential to understand how Nifty constituents are selected and how index valuation is calculated.

The Nifty index includes companies with the highest free-float market capitalization—that is, market cap excluding valuation of shares owned by promoters. However, from the index valuation perspective, the total market capitalization of firms should be considered. This means the combined market cap of firms entering the index should be compared with that of the companies being replaced.