Price vs. Value

Have you ever heard the story of the six blind men who come upon an elephant for the first time? (If not, you can read a version here) I ask because deciding whether the stock of a company trading at a certain price represents value has something in common with that fable. The more ways we look at that question, the more informed our opinion is. So, I was just writing this post about one way we look at that price/value question.

We look at how much each dollar of a stock’s price gets us in earnings and how that compares to other investment alternatives using an earnings yield. Earnings yield equals earnings per share divided by the share price (the reciprocal of the P/E ratio). It is quoted as a percentage, allowing an easy comparison to going bond rates. And that is usually how it is applied, as a tool to compare the earnings of a stock, sector or the whole market against bond yields. (The earnings yields of stocks should be higher than the yield of risk-free treasury bonds because they are riskier.)

As of 12/31/2008 Morningstar calculates the following P/E ratios for some popular indexes and from that we calculate the earnings yield:

	Forward P/E	Forward Earnings Yield
S&P 500	10.7	9.35%
NASDAQ	12.7	7.87%
MSCI EAFE	6.5	15.38%

Morningstar also calculates that the effective yield on the Lehman Brothers Credit (corporate bonds) Index is about 5.98%.

Based on these values, stocks seem undervalued relative to corporate bonds since the earnings yield for all these indices are higher than the yield on the corporate bond index. To put it another way, investing $100 in corporate bonds gets us $5.98 in interest over 2009 but $9.35 of earnings if we had invested in the stocks of companies in the S&P 500.

As we mentioned above, this is just one of many metrics we use when evaluating stocks and bonds. Given the economic weakness, it is very likely that we will see the estimates for corporate earnings decline markedly throughout the year and therefore the forward earnings yield will also decline. We also recognize that as shareholders, we will not receive every dollar that a company earns. A portion of those earning dollars may go to debt repayment, capital investments or acquisitions.

Still, this is an interesting metric to monitor. It would clearly indicate that investors should not be moving out of equities. It also would suggest that international stocks could be a very attractive investment in the future. But it is not foolproof, as this would have flashed a signal to by equities last year, and we all know how that turned out.

Back to the fable, the earnings yield may tells us what the ear or the trunk looks like, but we still do not have the complete picture of the elephant.