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Bond Equity Earnings Yield Ratio (BEER)

Bond Equity Earnings Yield Ratio (BEER)

What Is the Bond Equity Earnings Yield Ratio (BEER)?

The bond equity earnings yield ratio (BEER) is a metric used to evaluate the relationship between bond yields and earnings yields in the stock market.

The bond equity earnings yield ratio may likewise go by the plated equity yield ratio (GEYR).

Understanding the Bond Equity Earnings Yield Ratio (BEER)

BEER has two parts ā€” the numerator is represented by a benchmark bond yield, like a five-or 10-year Treasury, while the denominator is the current earnings yield of a stock benchmark, like the S&P 500.

A comparison of the yield on long-term government debt and the average yield on an equity market benchmark can be used as a form of indicator on when to buy stocks. On the off chance that the ratio is above 1.0 the stock market is supposed to be overvalued; a reading of less than 1.0 indicates the stock market is undervalued.

The theory behind the ratio is that in the event that stocks are yielding more than bonds, that is to say, BEER < 1, stocks are cheap given that more value is being created by investing in equities. As investors increase their demand for stocks, the prices increase, causing P/E ratios to increase. As P/E ratios increase, earnings yield decreases, aligning it more with bond yields.

Conversely, assuming that the earnings yield on stocks is less than the yield on Treasury bonds (BEER > 1), the proceeds from the sale of stocks are reinvested in bonds. This results in a decreased P/E ratio and increased earnings yield. Theoretically, a BEER of 1 would indicate equal levels of perceived risk in the bond market and the stock market.

Analysts often feel that BEER ratios greater than 1 imply that equity markets are overvalued, while numbers less than 1 mean they are undervalued, or that prevailing bond yields are not adequately pricing risk. Assuming the BEER is above normal levels, the assumption is that the price of stocks will decrease, hence lowering the BEER.

The formula for BEER:

BEER = Bond Yield/Earnings Yield

BEER is calculated by partitioning the yield of a government bond by the current earnings yield of a stock benchmark in the same market. The current earnings yield of the stock market (or simply an individual stock) is just the inverse of the price-to-earnings (P/E) ratio. The earnings yield is quoted as a percentage, which measures the percentage of each dollar invested that was earned by a company, sector, or the whole market during the past twelve months.

For example, on the off chance that the P/E ratio of the S&P 500 is 25, the earnings yield is 1/25 = 0.04 or 4%. It is easier to compare the earnings yield to bond yields than to compare the P/E ratio to bond yields.

The idea behind the BEER ratio is that on the off chance that stocks are yielding more than bonds, they are undervalued; inversely, in the event that bonds are yielding more than stocks, stocks are overvalued.

BEER Example

Consider a 10-year Treasury bond with a yield of 2.8% and the earnings yield on the S&P 500 at 4% (indicative of a P/E of 25x). The BEER ratio can accordingly be calculated as:
BEER=BondĀ Yield(0.028)/EarningsĀ Yield(0.04)=0.7\text=\text\left(0.028\right)/\text\left(0.04\right)=0.7
Utilizing the results above, an investor can conclude that the stock market is undervalued as the ratio is calculated to be below 1.0.

BEER versus Fed Model

The Fed model is a particular case of a bond equity earnings yield ratio. A BEER ratio can be calculated utilizing any benchmark bond yield and any benchmark stock market's earnings yield. The Fed model is a tool for determining whether the U.S. stock market is genuinely valued at a given time. The model is based on an equation that compares the earnings yield specifically of the S&P 500 with the yield on 10-year U.S. Treasury bonds.

Economist Ed Yardeni created the Fed model. He gave it this name saying it was the "Fed's stock valuation model, however nobody at the Fed ever authoritatively endorsed it." That's what the Fed model dictates assuming the S&P's earnings yield is higher than the U.S. 10-year bonds yield, the market is "bullish."

A bullish market assumes stock prices will rise and a great time to buy shares. In the event that the earnings yield dips below the yield of the 10-year bond, the market is considered "bearish." A bearish market assumes stock prices will decline. The Fed model didn't seem to work during and following the 2008 financial crisis. The widely used accepted model actually has many investing experts questioning its utility in recent years.

Limitations of the BEER

The bond equity earnings yield ratio helps investors understand the value created by investing one dollar in bonds versus investing that dollar in stocks. However, pundits have pointed out that the BEER ratio has zero predictive value, based on research that was carried out on historical yields in the Treasury and stock markets.

Likewise, creating a correlation between stocks and bonds is supposed to be flawed as the two investments are different in a number of ways ā€” while government bonds are legally guaranteed to pay back the principal, stocks don't promise anything. Likewise, unlike the interest on a bond, a stock's earnings and dividends are unpredictable and its value isn't legally guaranteed.

Features

  • The bond equity earnings yield ratio (BEER) is a way investors can use bond yields to estimate the direction of the stock market.
  • A ratio greater than 1.0 indicates the stock market is overvalued, while a rating of under 1.0 suggests stocks are undervalued.
  • The ratio is determined by separating the yield of a government bond by the current earnings yield of a stock or stock benchmark.
  • A particular example of a BEER that uses the S&P 500 and 10-year Treasuries is the purported Fed model.