Download Keep An Eye On The Earning Yield Of Equity Vs Bonds Indian

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Monday , October 03, 2011
Keep an eye on the earning yield of equity vs bonds
Publication: The Indian Express , Agency:Bureau
Edition:Pune/Chandigarh/Kolkata , Page No: 19 , Location: Top -Left , Size(sq.cms): 322
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■ STRATEGY
Keep an eye on the earning
yield of equity vs bonds
THE earnings yield
vis-a-vis 10-year
bond yield may
be an impor tant
indicator for
equity markets.
This ratio can
be used as a tool
to identify how
cheap or expensive the stock
market is rel ative to the debt
market, other capi tal
instrument available for
invest -' ing.
Earnings Yield = Earnings
per share divided by the
stock price
FOREXAMPLE,
If earnings per share for
the past four quarters = Rs
3 and the stock price = Rs
30, the earnings yield is 10
per cent.
The earnings yield is the
recip r o c a l o f t h e p r i c e -to earnings ra tio, 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 ex ceeded compared to
the stock where the
expectations are high. The
methodology used to calcu late the earnings yield of a
stock can be extended to
calculate the earnings yield
of an index.
Similarly, for the other
capital in -strument available
for investors -bonds - yields
are readily available and
indicate the returns that
they will provide to
investors who con tinue to
hold the bond till maturity.
The simplestversion ofyicld
is calcu lated 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.
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ST we see a softening of
interest rates in due course
and if earnings remain
stable then equities will
get cheaper than bonds,
most likely triggering a
rally in equities
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 thai even as suming 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.
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 FebruaryMarch 2009 when earnings yield
exceeded the bond yield and was
followed by a sharp rally in stock
markets.
Currently equ ity 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