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powered by bluebytes 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 Highlight KeywordsRemove Highlight Share News Export Options > Entire Page PDF JPEG Qualify Article ■ 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. All form fields are required. Your Email id 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