There are several models that have been developed to help us investors assess the basic questions that is often asked: "Is the market cheap?"
Here are several you probably should know:
Fed Model - this one is the simplest, developed by Edward Yardeni who noted the relationship betweent the US treasury bond yields and the earnings yield on equities. The model states that one should compare the forward earnings yield of the market (e.g. S&P 500) vs the 10 - year government bond yield.
If the forward earnings yield is greater than the 10-year government vbond yield, the market is cheap. Otherwise its expensive.
The model appears to be easy to use and is within the spirit of the discounted cash flow approach but there are issues with it. For one it ignores the future growth of the earnings yield. One stock market may have a big tech component and have a higher prospective future growth rate in earnings yield while another may be dominated by mature traditional businesses with low earnings growth but a higher earnings yield today. (growth stocks vs. value stocks)
Another issue is risk. The equity risk premium is totally ignored because you are essentially comparing a risk free investment in bonds with an investment in a basket of stocks which may be depressed for a prolonged period of time for various reasons such as regulation, poor government policies etc.
The last criticism is that it compares a real yield (since it is yield in the current period at current prices) with a nominal yield that is generated mainly in future periods.
Yardeni Model - this model attempts to address the above criticisms of the Fed Model.
this model compares the forward earnings yield of the stock market to A-rated corporate bond yeild - d x LTEG
where LTEG is the long term earnings growth rate and d the weight investors assign to future earnings growth projects which is historically 10%.
so if our forward P/E is 20x, our forward earnings yield is 5%
if our LTEG = 5%, d= 10% and yb =3.5% then
yb-d x LTEG = 3.5%-0.5% = 3% < forward earnings yield = 5% therefore the market is cheap!!
Cyclically Adjusted P/E Ratio (CAPE) - two kind men, Campbell and Schiller developed another way of trying to assess the market valuations based on the recommendations set out in Security Analysis (1934) text by Graham & Dodd.
The CAPE is a P/E ratio calculated over a 10-year period and adjusted for inflation. One can then compare it to current P/E levels to assess whether the market is currently cheap or expensive.
Tobin's Q and Equity Q - these methods wre originally developed by Brainard and Tobin to assess both market valuations and also capital investment decisions.
The Tobin's Q formula is as follows
Tobin's Q ratio = (Equity Market Value + Liabilities Market Value) / (Total Assets at Replacement Cost)
The idea is that an undervalued company would have a Tobin's Q of less than 1. Such a firm could be considered a good investment.
In some cases an alternative formula is used called Equity Q
Equity Q = Equity Market Value / (Total Assets at Replacement Cost - Market value of Liabilities)
Here are several you probably should know:
Fed Model - this one is the simplest, developed by Edward Yardeni who noted the relationship betweent the US treasury bond yields and the earnings yield on equities. The model states that one should compare the forward earnings yield of the market (e.g. S&P 500) vs the 10 - year government bond yield.
If the forward earnings yield is greater than the 10-year government vbond yield, the market is cheap. Otherwise its expensive.
The model appears to be easy to use and is within the spirit of the discounted cash flow approach but there are issues with it. For one it ignores the future growth of the earnings yield. One stock market may have a big tech component and have a higher prospective future growth rate in earnings yield while another may be dominated by mature traditional businesses with low earnings growth but a higher earnings yield today. (growth stocks vs. value stocks)
Another issue is risk. The equity risk premium is totally ignored because you are essentially comparing a risk free investment in bonds with an investment in a basket of stocks which may be depressed for a prolonged period of time for various reasons such as regulation, poor government policies etc.
The last criticism is that it compares a real yield (since it is yield in the current period at current prices) with a nominal yield that is generated mainly in future periods.
Yardeni Model - this model attempts to address the above criticisms of the Fed Model.
this model compares the forward earnings yield of the stock market to A-rated corporate bond yeild - d x LTEG
where LTEG is the long term earnings growth rate and d the weight investors assign to future earnings growth projects which is historically 10%.
so if our forward P/E is 20x, our forward earnings yield is 5%
if our LTEG = 5%, d= 10% and yb =3.5% then
yb-d x LTEG = 3.5%-0.5% = 3% < forward earnings yield = 5% therefore the market is cheap!!
Cyclically Adjusted P/E Ratio (CAPE) - two kind men, Campbell and Schiller developed another way of trying to assess the market valuations based on the recommendations set out in Security Analysis (1934) text by Graham & Dodd.
The CAPE is a P/E ratio calculated over a 10-year period and adjusted for inflation. One can then compare it to current P/E levels to assess whether the market is currently cheap or expensive.
Tobin's Q and Equity Q - these methods wre originally developed by Brainard and Tobin to assess both market valuations and also capital investment decisions.
The Tobin's Q formula is as follows
Tobin's Q ratio = (Equity Market Value + Liabilities Market Value) / (Total Assets at Replacement Cost)
The idea is that an undervalued company would have a Tobin's Q of less than 1. Such a firm could be considered a good investment.
In some cases an alternative formula is used called Equity Q
Equity Q = Equity Market Value / (Total Assets at Replacement Cost - Market value of Liabilities)
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