Amazon deals

Thursday, March 17, 2011

Using Earnings Yield (E/P) to time your investments – a guest post

In last Thursday’s post, I had taken a look at the historical P/E ratios of the Nifty 50 index and suggested an investment strategy. In this month’s guest post, Nishit takes a slightly different view. He compares Nifty’s earnings yield with the 10 years G-Sec yield to time stock market investments.

-------------------------------------------------------------------------------------------------------------

Subhankar had written about Nifty’s P/E multiple or Price to Earnings Multiple last week. Let us delve deeper into it. He had written “Nifty’s P/E ratio has varied between 11 and 27 during the past 12 years - with peaks of 27.35 on Mar 1, 2000 and 27.64 on Jan 1 2008, and troughs of 11.62 on Jan 1, 1999; 10.86 on May 2, 2003 and 11.76 on Dec 1, 2008. The average P/E ratio over the past 12 years is 18.24.”

image

Price/Earnings ratio is nothing but the Market Price divided by the Profits per share of a company in rupee terms. Assume the share price of a company is Rs 100 and it makes a profit of Rs 10. So its P/E ratio is 100/10 = 10. It is a very fundamental ratio of finding out the valuation of a stock (or index). Now, P/E by itself has no significance. How do we know if P/E of 10 is stretched or P/E of 50 is stretched?

We look at the growth prospects of a company and sector. The derived ratio is PEG Ratio (Price to Earnings Growth ratio). Now if the company is going to grow at an annualized growth rate of 100% for the next 3 years, a P/E of 100 may be acceptable. This is especially true of the IT companies in the glory days of 1998-2001 when Infosys used to come out with 100% growth figures every quarter.

The inverse of P/E (i.e. E/P) is the earnings yield. It is the amount per annum you are going to earn by investing in a company. This ratio is very important in the sense that you can use it to find if a stock (or the Nifty) is over-valued or not. What will we compare against? Let us take the 10 years Government Treasury Bill return. This is the safest investment in the country. Whenever 10 years G-Sec yield is more than equity earnings yield that is the time to go long big time.

Let us take an example. During Oct ’08 – Mar ’09, the Nifty P/E ratio dropped below 15; the earnings yield was 6.66% and below. The G-Sec Yield was 7.83% in Nov ’08.That was the time when the long term portfolio of stocks should have been built up.

For the past 1 year, the Earnings Yield of the Nifty has been around 5%. The G-Sec yield is around 8%. At such times, exposure to equity has to be limited. That is, keep trailing stop losses and don’t add fresh equities.

The Earnings Yield is a simple extension of the P/E concept and comparing it to the Bond Yield gives us a perspective on finding whether the equity markets are overvalued as compared to the Bonds Market or not.

clip_image002[4]

-------------------------------------------------------------------------------------------------------------

(Nishit Vadhavkar is a Quality Manager working at an IT MNC. Deciphering economics, equity markets and piercing the jargon to make it understandable to all is his passion. "We work hard for our money, our money should work even harder for us" is his motto.

Nishit blogs at Money Manthan.)

11 comments:

essentialassociate said...

Pretty interesting read...
Even I am quite intrigued by earnings yield.

Ganpat said...

Thanks for this useful article.
I have a doubt
The author says //Whenever 10 years G-Sec yield is more than equity earnings yield that is the time to go long big time.// and adds
//For the past 1 year, the Earnings Yield of the Nifty has been around 5%. The G-Sec yield is around 8%. At such times, exposure to equity has to be limited. That is, keep trailing stop losses and don’t add fresh equities.//
The rule and the example are not matching.Pl.clarify
Thanks and regards,

TK said...

Thanks Nishit for this wonderful post. I quite agree with you. Actually I have been using BANK FDs to compare with returns from NIFTY. But you did the comparison with G-Sec returns. G-sec yields is no doubt the best comparison, but you have to attach risk premiums as well.
e.g Stocks are always risky as compared to G-Sec yield. A big natural calamity can tank stock markets, but G-secs will be steady in that case. So the difference between 5% and 8% is much higher when risk is taken into account.

Also, you have taken Current PE ratio, or PE ratio which has been calculated from last year performance. Where has G-sec promises a return in future. If we consider that companies can grow with a CAGR of 20% per annum, the 5% yield from stocks can be as attractive as a 8% return from any other investment.

BR//Tapas

Nishit Vadhavkar said...

Sorry my mistake.
It should read whenever Equity Earnings yield is more than G-Sec yield, go long.

Madhu said...

Nishit - I still have some doubt.

" the earnings yield was 6.66% and below. The G-Sec Yield was 7.83% in Nov ’08.That was the time when the long term portfolio of stocks should have been built up."...

Here E/P is not less than G-sec yield.. Then why shud we buy equities. Also, please share if you have some stats on portfolio performance if this rule if followed. That would be helpful.

Thanks a lot!

Doctor Universe said...

Nishit I am also having the same doubts as expresssed by Ganpat and Madhu. Please help in clarifying...

Nishit Vadhavkar said...

Let me clarify. In Dec 08, the G-Sec Yield was 6.6 pc. At the same time, the Nifty P/E was at 10-11 meaning the Earning Yield was around 9.

In a nutshell, when Earning Yield (1/ (P/E)) more than G-Sec Yield buy Equities.

I could have elaborated more clearly. Sorry for the Confusion.

BVS said...

Thanks for the informative article.

Is the above observation sector specific? or nifty based?

Regards,
Bhushan

BVS said...

where do we find historical g.sec data?

thanks,
bhushan

Nishit Vadhavkar said...

Its Nifty specific. One cannot compare G-Sec Yield with a sector.Nifty represents the Indian economy. G-Sec Yield I got fromthis site
http://www.tradingeconomics.com/Economics/Government-Bond-Yield.aspx?Symbol=INR

Subhankar said...

(This comment was posted by Madhu - accidentally deleted by me.)

Nishit - If you have some data on portfolio performance if this strategy is followed, please share it.

Also, let us know how many times in the past 10 yrs earnings yield was greater than Gsec. This will tell us about the practical application of this strategy.

Thanks a lot!