What is the difference between Earning yield and Bond yield?
Earnings yield simply refers to the percentage of a company’s earnings per share. Most of the companies will have shown earnings per share (EPS) in the profit and loss statement. Divide it by the current market price of the stock, and you will get the earnings yield. It is also an inverse of the P/E ratio.
Bond yield refers to the yield that an investor actually realizes on a bond, calculated as interest income on the bond divided by the current market price of the bond.
Let us have a brief lookout on both these yields with some number crunching involved.
Earnings yield= EPS/Current market price
Bond yield= Annual coupon payment/Face Value of bond, assuming the market price is equal to the face value of the bond.
Calculations might get a bit complicated if the above assumption is not considered. However, for this reading, we can consider bond yield as simply a risk-free rate (earned on a safe government bond investment) that exists in the market.
Earnings yield vs Bond yield
Earnings yield is used by investors to gauge the market conditions; whether the equity markets are overvalued or undervalued by comparing it to the bond yield. Investing in equities is riskier than investing in bonds especially government bonds. And hence, investors can expect to be rewarded more in bond yields by added risk premiums.
If the earnings yield falls below the interest rates or bond yield, then equity markets can be said to be overvalued. If the earnings yield is higher than bond yield, then stocks, in general, may be considered as undervalued.
Earnings yield vs P/E
While P/E is nothing but the current market price divided by the EPS, the inverse of that becomes earnings yield. However, earnings yield is not as popular as P/E. Both can be used as a relative measure in the valuation process. Earnings yield is a straightforward and easy to understand metric. However, there is no mathematical advantage from one over the other. An investor is advised to use whichever is convenient.