Personal Finance: Neat ratio lets you weigh risks of bonds

Personal Finance: Neat ratio lets you weigh risks of bonds

April 13th, 2011 by By Travis Flenniken in Business Diary

Incorporate "beer" into your investment analysis.

Not the kind that comes in a six-pack, but rather the kind that can be derived by examining the price and returns of bonds and equities.

The bond equity earnings yield ratio, or "Beer," allows an investor to easily compare the risk and expected return of an equity investment to the risk-free return to help determine if it is fairly valued.

Ratios are used to make comparisons between two things. In the financial industry, they are very helpful at evaluating one asset's value relative to another. All investments should be compared against a risk-free option, a U.S. Treasury bond, to determine whether the expected return of the investment justifies its extra risk.

The two components of the Beer are bond yield and equity earnings yield.

Bond yield is the annual income payment as a percentage of the purchase price. Ten-year Treasury bond yield represents the risk-free return an investor will get if he buys and holds until maturity.

Earnings yield is the reciprocal of the price-earnings or "P/E" ratio. It is quoted as a percentage, which makes it easier to compare with a Treasury bond's risk-free rate of return.

For example, a stock with a P/E of 15 has an earnings yield of 6.7 percent. The higher the P/E (price paid for a dollar of earnings), the lower the earnings yield. Conversely, a higher earnings yield means a stock is trading at a lower price relative to earnings.

The earnings yield of a stock, an industry, or even an index, such as the S&P 500, can be compared against the risk-free rate of return to determine relative value.

Stocks are inherently more risky than bonds, especially Treasuries, so they should yield a higher return. However, there are occasions when stocks are yielding less than bonds; which means the equity investor is essentially not getting a return consummate with his exposure to risk.

In the summer of 2007, Beer was less than 1 percent. The S&P 500 Index P/E ratio was 17.7, which makes the earnings yield 5.65 percent.

The 10-year Treasury yield was 5.10 percent, making the spread 0.55 percent. Investors were willing to accept a significantly higher level of risk for only 0.55 percent more return. Within one year, the S&P 500 fell about 20 percent, but corporate earnings fell even more, bringing the earnings yield to 4.0 percent. The 10-year Treasury rate was 4.1 percent - the Beer was negative.

During 2008 and parts of 2009, trailing 12-month corporate earnings were falling even faster than equity prices, making equities look expensive (or too risky) relative to Treasuries. The Beer was either less than 1 percent or negative throughout this period of time. By the end of 2009, corporate earnings had begun to recover. The Beer was over 1 percent by March 2010.

The current earnings yield on the S&P 500 is about 6.3 percent and the 10-year Treasury is 3.6 percent, making the spread 2.71 percent. The Beer has shrunk slightly in the last six months as the S&P 500 has increased in value by about 13 percent, but it is still yielding more than Treasuries. Many investors consider this a bullish sign.

Of course, if corporate earnings decline or if bond yields rise, that spread will tighten, and sentiment may change quickly. High energy costs could be a catalyst for such a change as rising fuel costs impede earnings growth and can cause higher inflation, spurring higher bond rates.

The Beer serves as a "sanity check" when equity prices rise disproportionately to corporate earnings. It looks at the present and the past, but to be highly useful in making investment decisions, it should be accompanied by conviction on the direction of future corporate earnings and interest rates.