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 MARKET REPORTS |
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Analyst report - shares
Earnings yield an omen of doom?
July 29, 2007
Brendon Lau, ShareAnalysis
 The S&P/ASX 200 Index has enjoyed a stellar run over the past year and as we head into the reporting season, some analysts are scratching around looking for clues as to whether the market has crossed over into expensive territory. One such clue cited in the media is ‘earnings yield’, but how accurate is this?
Calculating the earnings yield gives investors an easy way to compare stocks to bond yields. Instead of dividing price by earnings-per-share (EPS), as you do for PE ratios, you divide the EPS by the price. The result is quoted as a percentage. You can apply the formula to the entire market or just to groups of stocks.
Generally speaking, the earnings yield on the stock market should be higher than the benchmark Treasury bond yield to reflect the relatively riskier nature of the stock market. The higher the earnings yield is over the bond rate, the better the value of the stock market. According to the Australian Financial Review, the earnings yield on the Australian MSCI Index and the US stock market is currently the same at 6.5%. The difference though is that the 10-year US Treasury bond is currently yielding around 5%, while its Australian counterpart is yielding 6.15%. This means that there is hardly any risk premium built into Australian shares. This situation could deteriorate further, as Australian bond yields have been moving up on expectations that the Reserve Bank of Australia will raise interest rates in the not too distant future.
Investors should be alert, not alarmed. Earnings yield in itself is not likely to bring the market down and we think there is still a decent amount of room to grow, especially considering the above trend economic growth predicted for Australia and the region. Also, the ever-important Chinese economy is growing at its fastest pace in 12 years.
Furthermore, we are forecasting forward PEs on the stocks we cover to fall over the next two years as EPS continues to grow, albeit at a much lower rate of 7.4% for FY08 compared with 14.7% for the year before. This is an indication that the earnings yield could improve, as PEs and earnings yields move in opposite directions. What is even more reassuring is the very weak statistical link between our sharemarket performance and the premium between earnings yields of Australian stocks and Treasury yields. Proponents of the earnings yield theory believe that as the gap between stocks and bonds decreases, the stock market moves more into the overvalued space. However, over the past four years, the correlation between the S&P/ASX 200 and the yield premium is -0.5%, a sign that the two move quite independently of each other.
Brendon Lau is the Editor of ShareAnalysis, a premium retail investment service offered by Aegis Equities Research. For more information on these stocks and for a free trial of its web-based investor research services, please go to the ShareAnalysis website.
More articles from this week's CompareShares newsletter:
International investing: Chinese whispers
Uranium & Iron ore: Unfashionable metals back in vogue
Resident trader: Learn from your losing trades
Commodities: Which is the most popular to trade?
US plunge: Markets around the world are marching in lock step
Super: Young savers need to rethink super
Shares: Why technical analysis matters
Stock of the week: ADO
Warrants: Instalment pricing explained
Shares: Chief ratios for stock hunters
Super: The Y2K of super in 2007
Please note that CompareShares.com.au simply publishes analyst reports on this page. The publication of these reports does not in any way constitute a recommendation on the part of CompareShares.com.au. You should seek professional advice before making any investment decisions.
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