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Keep an eye on the earning yield of equity vs bonds

The earnings yield vis-a-vis 10-year bond yield may be an important indicator for equity markets.

The earnings yield vis-a-vis 10-year bond yield may be an important indicator for equity markets. This ratio can be used as a tool to identify how cheap or expensive the stock market is relative to the debt market,other capital instrument available for investing.

Earnings Yield = Earnings per share divided by the stock price

For example,

If earnings per share for the past four quarters = Rs 3 and the stock price = Rs 30,the earnings yield is 10 per cent.

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The earnings yield is the reciprocal of the price-to-earnings ratio,which would be 30/3,or 10. A high earnings yield indicates that the market is assuming a lower growth in profits in the future for the company while a low earnings yield indicates that the company is expected (by the market) to have high profit growth for an extended period of time. An expectation of low profitability in the future has a better probability of being exceeded compared to the stock where the expectations are high. The methodology used to calculate the earnings yield of a stock can be extended to calculate the earnings yield of an index.

Similarly,for the other capital instrument available for investors – bonds – yields are readily available and indicate the returns that they will provide to investors who continue to hold the bond till maturity. The simplest version of yield is calculated using the following formula: yield = coupon amount/price. When you buy a bond at par,yield is equal to the interest rate. When the price changes,so does the yield.

A comparison of the yield between the two capital instruments,equity and debt,can be used to assess the risk-reward for investing.

History suggests that earnings yield-to-bond yield may be a very important tool to indicate how much the equity markets are expensive or cheap relative to bond markets. This tool has been a very important indicator to identify bottom of the equity market. Whenever earnings yield have crossed bond yields,it implies that even assuming nil earnings growth in perpetuity equity will deliver better returns than debt. Similarly,when equity yields are lower than bond yields,it indicates that equities are expensive than bonds.

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Whenever we have seen sharp drops in interest rates,like during 2003-2005 when interest rates declined sharply and equities became quite cheap compared to bonds. It was followed by a sharp rally in equity markets. Similar,was the experience in February-March 2009 when earnings yield exceeded the bond yield and was followed by a sharp rally in stock markets.

Currently equity yields are almost at par with bond yields indicating both these capital assets are balanced in value terms. But if we see a softening of interest rates in due course and if earnings remain stable then equities as an asset class will get cheaper than bonds,most likely triggering a rally in equities.

— Author is Head-Equity,Birla Sun Life Insurance

First published on: 03-10-2011 at 01:57 IST
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