When it comes to determining a fair value for equities, interest rates are an important variable to consider.
As rates rise or fall, they affect the appropriate valuations for different stocks in different ways. This article provides a brief overview of how that works.
The Equity Risk Premium
Equities are not priced in a vacuum; they are always compared to other alternatives.
Specifically, safe sovereign bonds are the main comparison. If you live in a developed country and buy sovereign bonds and hold them to maturity, your only risk is inflation risk. There’s virtually no chance of nominal default, since the issuer of the bond is also the issuer of the currency. There’s typically plenty of liquidity in developed sovereign bond markets as well, so these are considered pristine collateral. In particular, the United States 10-year Treasury yield has been a de facto benchmark for a long time.
Suppose you could get a 5% annual yield on a 10-year Treasury note, and annual inflation is about 2%. You’re making a positive 3% real yield, which is great for a risk-free investment. What would it take for you to buy, say, a dividend stock instead?
The answer is you’d need a much higher than 5% expected return from that stock in order to take on increased volatility and business risk. Maybe, for example, you would do it if you could get a 9% expected annualized return over the next 10 years. In other words, you would be demanding a 4% equity risk premium, meaning a 4% better annualized return than the risk-free alternative, in order to take on that increased volatility and uncertainty.
Now, suppose a decade later, you’re in an environment where you only get a 1% annual yield on a 10-year Treasury note, and annual inflation is about 2%. You’re making a -1% real yield, which is a gradual destruction of purchasing power. In fact, you could say the price-to-earnings ratio of that 10-year note is 100, since you’re only getting a 1% return on your capital per year. Naturally, you’d be reaching for some other store of wealth. What would you pay for a good stock?
Well, if you still want an equity risk premium of 4%, then you’d be willing to buy stocks that only offer the prospect of 5% long-term annualized returns. In other words, you’d be willing to buy rather highly-valued stocks, since you’re comparing them to very highly-valued bonds and have few other options for liquid mainstream investments.
However, in doing so, the investor must consider the probability that interest rates will rise, and reduce the valuations of their stocks during their holding period.
Cyclically-Adjusted Earnings Yield
There are various ways to measure an equity risk premium.
The most complete way is to do discounted cash flow analysis or other return assessment of a specific investment, and compare that to the 10-year Treasury note yield to maturity.
However, investors also want a high-level snapshot of general conditions, so we need some basic calculations to compare broad equities vs Treasuries. For that, a popular calculation is the S&P 500 earnings yield (the earnings per share divided by the share price) minus the 10-year Treasury note yield. That can also be adjusted to use the forward consensus earnings yield instead of the trailing yield.
My preferred way to measure the equity risk premium, however, is the cyclically-adjusted earnings yield of the S&P 500 minus the current 10-year Treasury yield.
This is because S&P 500 earnings in any one year, especially during a recession or a brief economic boom, can be a poor representation of their average earnings capability over a full business cycle. So, this calculation takes the inflation-adjusted average of the last ten years of earnings, and divides that by the current share price. That gives you the cyclically-adjusted earnings yield, which can then be compared to the 10-year Treasury rate.
Source: Lyn Alden
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