Why Stocks are Still Cheaper in Relation to Bonds?

It is a fact that U.S. stock prices are at their highest historical level. But for someone to decide whether to keep their shares in their portfolio in the new year, it will be the wrong strategy to look at how high their share prices can go.

What matters to the investor is that the shares he holds have higher returns (margins) than alternative floating-value investments that are not other than bonds and more specifically the actual returns offered by government bonds, and not in relation to historical returns on shares.

This positive margin in the returns we propose   under consideration is shown by the margin that exists between the S&P500 forward earnings yield and the real five-year Treasury yields.

But to start our analysis, the first useful indicator that we should consider is:

  • The Earnings yield = (E/P),           όπου E: earnings per share, P: price per share.

This indicator shows us our expectations for the returns of the shares under consideration. In 1988, the study of the John Y. Campbell & Robert J. Shiller με τίτλο “The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors”, The Review of Financial Studies, Volume 1, Issue 3, July 1988, Pages 195-228, https://doi.org/10.1093/rfs/1.3.195, proved that the yields on equities help investors to predict long-term returns.

All else being equal, you should be less keen to hold equities (or keener to hold some equities) the lower earnings yield is.

To examine the fluctuation in stock yields we can use the following indices

  • Dividend Yield = d/P        where: d: dividend per share, P: price per share

It is the current annualized dividend paid on a share of common stock, expressed as a percentage of the current market price of the corporation’s common stock. Thus a 15% dividend on a $5 stock will pay 500cents*0,15 = 75cents. Thus, if the market value of these stock is now $10, the dividend yield would be 5/10*0,15 = 0,075 or 7,5%.

  • Price/Earnings ratio = (P/E)

It is the inverse ratio of the earnings yield. A corporation’s current stock price divided by its earnings per share. P/E ratios are used by investors and analysts to determine the relative value of a company’s shares to compare it with other companies’ P/E shares ratio which are in the same industry. It can also be used to compare a company against its own historical record or to compare aggregate markets against one another or over time.

A high P/E ratio could mean that a company’s stock is over-valued, or else that investors are expecting high growth rates in the future and vice-versa.

  • Price-Earnings Relative = (P/E) / market’s forward earnings

where market’s forward earnings: Actual reported earnings over a 12-months period

Price-earnings relative refers to the price-earnings ratio of a stock divided by the price-earnings ratio of a broader market measure. The price-earnings ratio, often written as P/E, is equal to a stock’s or broad market’s market price divided by a measure of the stock’s or market’s earnings.

A price-earnings relative value of less than 1 indicates that a stock has a lower P/E ratio than its broader industry. A price-earnings relative value of 1 indicates that a stock has the same P/E ratio as its peer group. A price-earnings relative value of greater than 1 indicates that a stock has a higher P/E than its peer group.

A P/E value lower than the peer group and a corresponding price-earnings relative value of less than 1 may be an indication that the stock is trading cheaply, representing a good time to buy. The rationale for this conclusion is that a lower P/E indicates that each dollar of earnings costs less for this stock than for the average stock in the peer group. The reverse is true if the P/E for the stock is greater than that of the peer group and the price-earnings relative value is greater than 1, which may be an indication that the stock’s earnings are more expensive than the average stock in the peer group.

  • Trailing Price-To-Earnings (Trailing P/E) = Current Share Price / Trailing 12-month EPS

Trailing price-to-earnings (P/E) is a relative valuation multiple that is based on the last 12 months of actual earnings. It is calculated by taking the current stock price and dividing it by the trailing earnings per share (EPS) for the past 12 months. Trailing P/E can be contrasted with the forward P/E which instead uses projected future earnings to calculate the price-to-earnings ratio.

The earnings for the most recent fiscal year can be found on the income statement in the annual report. At the bottom of the income statement is a total Earnings Per Share (EPS) for the firm’s entire fiscal year. Divide the company’s current stock price by this number to get the trailing P/E ratio.

  • Price-To-Sales (P/S)

The price-to-sales (P/S) ratio is a valuation ratio that compares a company’s stock price to its revenues. It is an indicator of the value that financial markets have placed on each dollar of a company’s sales or revenues.

The P/S ratio is typically calculated by dividing the stock price by the underlying company’s sales per share. A low ratio could imply the stock is undervalued while a ratio that is higher-than-average could indicate that the stock is overvalued and vice-versa. One of the downsides of the P/S ratio is that it does not consider whether the company makes any earnings or whether it will ever make earnings.

However, since the profits of companies may not follow a steady course within a certain period, it is useful to use a time horizon of between five and ten years in terms of stock returns.

  • CAPE ratio = Share Price / 10-year average, inflation-adjusted earnings

The CAPE ratio is a valuation measure that uses real earnings per share (EPS) over a 10-year period to smooth out fluctuations in corporate profits that occur over different periods of a business cycle. The CAPE ratio, using the acronym for cyclically adjusted price-to-earnings ratio, was popularized by Yale University professor Robert Shiller. It is also known as the Shiller P/E ratio. The P/E ratio (see above) is a valuation metric that measures a stock’s price relative to the company’s earnings per share. EPS is a company’s profit divided by the outstanding equity shares.

The CAPE ratio is used to analyze a publicly held company’s long-term financial performance while considering the impact of different economic cycles on the company’s earnings. The CAPE ratio is like the price-to-earnings ratio and is used to determine whether a stock is over-or under-valued.

The limitations of the CAPE ratio contend that it is not especially useful since it is inherently backward-looking, rather than forward-looking. Another issue is that the ratio relies on GAAP (generally accepted accounting principles) earnings, which have undergone marked changes in recent years.

  • The price of assets should equal expected cashflows discounted over the life of the asset. The earnings yield shows you the “expected” part of this equation; real bond yields cover the “discounted” part.  The gap between these two is a forward-looking measure of the equity risk premium, the excess return for holding shares.

This extra cash (extra reward) in the long-run over the safe investments is indicated by the Equity risk premium-the discount rate. In other words, the equity risk premium is equivalent with the expected return on equities. This risk premium for US equities (and any other developed financial market) is given by the following equation:

Equity risk premium = S&P 500 earnings yield – real 5-year Treasury Bond yield

To estimate the equity risk premium for an individual stock you must replace the S&P 500 earnings yield in the above equation with the individual stock earnings yield.

The higher the risk premium on stocks, there are more probabilities that the investors to decide to tilt their portfolios away from government bonds (safe assets) and vice-versa.

Those investors which have a long-term perspective on their investments might find more profitable to use this measure-tool (equity risk premium) to construct an investment portfolio based on a mixture of risky stocks and government bonds (safe investments) and a percentage in cash (for more information about the returns of assets as an investment selection criterion please read the analysis titled «The Low Interest Rates, their Consequences & the Returns of Assets as an Investment Selection Criterion»).

The equity risk premium is higher now relative to the past (US and in other financial markets of the world). The decade of 1990’s during the dotcom boom, the risk premium for owning stocks was negative – real interest rates were a handsome 4%. Now real interest rates across the developed world are negative.

 We can conclude that despite high prices, equities are attractively priced relative to bonds – even in America, but also in other stock markets of the world. Only a high increase in real long-term interest rates all over the world would cause a downturn in the high asset prices.

 

 

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Trust Economics is a specialized independent economic research, analysis and consultancy business. Our team provides ingenious analysis in the macro & micro economic field, in the field of financial market, regional and sectoral analysis equally, forecasts, consultancy, specialized studies-research/projects from its headquarters in Athens, Greece.

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