Using the inverse of P/E to read markets better

With the local stock markets rallying more than 65% from the bottom seen in March 2009, the “valuation debate” is back in vogue. Though absolute valuations are always debated, relative valuations are hardly discussed. We shall discuss relative valuations here. But first some basics.

A traditional method used to value stocks for years now is the price to earnings (P/E) ratio. It is the multiple of the earnings the stocks or markets in general are valued at. The key question here is — how many times the earnings is the market willing to pay to buy a certain stock?

The P/E ratio may be based on historical or estimated earnings. Earnings can be estimated with minimum assumptions (such as GDP growth rate), historical data and growth rate. The current P/E ratio is then compared with its own historical averages to value the individual stock or markets.

Similarly, bonds (government) are valued based on their yield to maturity (YTM). That’s the expected return if the bonds are held to maturity and the governments don’t default. For instance, the most traded bond in Indian markets is the 10 year (long term) benchmark ‘government bond’. Bonds are valued taking into account various macroeconomic factors such as GDP growth rate, inflation, currency, liquidity, central bank stance, supply and demand, etc. Historical averages of YTM on such bonds are used to value the yields on current bonds vis-a-vis the prevailing economic cycle.

Though the stocks and bonds have been historically valued independently, many a times investors don’t realise that there is a strong link between the valuations of the two asset classes since in the long run, the macro economic factors influencing both the asset classes are very similar. For instance, cost of funds (interest rates) influences the earnings of companies and government bond yields set the tone for interest rates in India. Or GDP growth rate is a crucial input for valuing stocks as well as bonds. The interest rates are also used for discounting future earnings of companies in the now famous valuation technique, discounted cash flows (DCF).

Traditionally, stocks and bonds have always been valued on a standalone basis. But the link between stocks and bonds that we just discussed can be effectively used for “relative asset class valuation,” viz, over or under valuation of stocks relative to bonds or vice versa. We all know what dividend yield is; it is dividend received divided by the price of a stock.

If we presume that all the earnings of the company are distributed to shareholders as dividends, the dividend yield can also be termed as the ‘earnings yield’, which is nothing but the inverse of P/E ratio. For instance, if the P/E ratio is 20, the earnings yield is 5% (1/20).

Since future earnings are always uncertain, the earnings yield also carries some risk of not being realised. Since it is risky, the earnings yield has to be higher than the 10 year government bond yield, which is almost assured on maturity. The excess of the expected earnings yield over the 10 year government bond yield is nothing but the equity risk premium, or the extra returns to compensate the investors for the extra risk undertaken.

The difference in the earnings yield and the bond yields often gives a perspective of relative asset valuation, making either of the stocks or bonds relatively cheaper or expensive. Such relative valuation can be effectively used as additional input to value stocks.

Higher the difference in the earnings yield and the bond yields, cheaper is the relative valuation of stocks and vice versa, since the investors are getting compensated more for higher risks taken for stocks. So, higher the difference, cheaper the stocks, assuming everything else remains the same.

In the Indian stock market context, historically (last 10 years) whenever the difference between earnings yield and bond yield (henceforth EYBY) has peaked at around 2-2.50% or higher, the Sensex has bottomed out and delivered good returns from there. And usually, whenever EYBY is low or negative at around minus 5% or lower, the Sensex has peaked and returned negative.

For instance, when the Sensex bottomed in March 2009 at around 8200, EYBY was at the higher end of the band at 2.1%. When the Sensex peaked at around 20500 in January 2008, EYBY was almost at minus 4.50%, closer to minus 5%. This tool can be effectively used as an incremental or additional input, along with fundamental research, before buying/ selling in the markets.

Historically, the tool has been useful in identifying the mid-term “turning points” in the markets. The data points for the same are easily available on the internet for retail investors to take advantage of. A caveat: Liquidity (internal & external) can distort the indicator and the tool has to be used in tandem with other fundamental research.

The writer is a qualified chartered accountant and an independent financial expert.