Bond Yields vs. Equity Yields

a close up of United States Treasury Bonds

Jitalia17 / Getty Images

In the 1987 shareholder letter to GEICO stockholders, Lou Simpson, one of the most successful investors of all time, described what he looked for in a potential investment.

His thoughts to stockholders included "think independently", "invest in high-return businesses run for shareholders," "pay only a reasonable price, even for an excellent business," "invest for the long-term," and "do not diversify excessively.

He also mentioned a concept that is rarely touched upon by other gurus—the long-term treasury yield and how it has important implications for valuating a company determining its relative attractiveness as an investment.

Long-Term Treasury Bonds

For some reason, people have a need for benchmarks; standards against which all other things must be measured so that we can compare ourselves. On Wall Street, investment returns benchmarked against long-term Treasury bond yields.

Treasury bonds, issued by the Federal Government to raise funds for day-to-day operating needs, have become known as the “risk-free” rate because there is no reasonable chance of loss if held to maturity. The U.S. government has yet to default on its debts—thus, bond-holders are relatively certain they will be paid upon maturity.

The theory behind using Treasuries as a benchmark is that if an investor can recieve a risk-free investment at a specific rate of return, all other investments should queue from that investment based on the amount of risk they present to investors.

Most investors don’t consider risk to return this way. Instead, they may look at shares of Coca-Cola and determine that at a price-to-earnings ratio of 25.36 (which means an earnings yield of 3.94%) they aren’t willing to invest.

Or, they may conclude that Coke has growth prospects – whereas the treasury does not – and it has the ability to weather a storm in the event of widespread inflation. People are still going to drink soda, even in the midst of a great depression because it is, as the company has pointed out, an “affordable luxury.”

Risk Premium

The difference between the earnings yield of a particular stock or asset and the long-term bond yield is known as the “risk premium”. It’s supposed to factor in all sorts of things like your expectation for inflation, growth, the certainty with which you have about the future cash flows (that is, the surer you are about your future predictions for earnings per share, the less of an equity premium you would likely demand). In essence, it is a very rough gauge for telling you how much relative profit you are getting for each dollar invested.

Economists love to take the estimated risk premium for the market at any given time and compare it to the past. Often, this can reveal widespread over or undervaluation. Think back to the dot-com bubble. At its height, the S&P 500 had a price-to-earnings ratio in excess of 60. This is an earnings yield of only 1.67%. At the time, the risk-free rate was roughly 5.90%.

That means that people were able to make 5.90% without any risk, but given the chance of wipeout from risky, newly formed companies, they demanded only 1.67%! It’s no wonder that long-term value investors were sounding the warning. During such speculative orgies, however, the reason is often derided as a Cassandra; an inconvenience that simply doesn’t understand that things are “different this time.”

A Real-World Example of How This Could Have Saved You from Losses

That’s why it’s frustrating for highly informed investors to hear some of the nonsense that is spouted off by laymen and analysts alike. Before the departure of Robert Nardelli in early 2007, I wrote an article about the troubles at Home Depot.

The point was (and remains) that investors were furious at him for a huge pay package, despite more than doubling profits, dividends, earnings per share, store count, and diversifying into other related fields, because the stock price had crashed in half. With all due respect, that’s because, during the bubble, the retailer’s shares reached a stupid – absolutely stupid – valuation of 70 times earnings.

That’s an earnings yield of 1.42%. Had Nardelli and his team not executed so well, the crash back to reality would have been far greater than the 50% drop. Anyone purchasing the stock at those prices should have their head examined.

Yet, like the smoker that blames Philip Morris or the obese diabetic that despises McDonald's, many of these shareholders had the audacity to complain and chose the CEO as a scapegoat. Enron, Worldcom, and Adelphia, this was not.

Here, as the line from antiquity goes, the fault lies not in the stars, but with us. Had the shareholders focused on the relationship between long-term bond rates and earnings yield, they could have saved themselves a lot of financial and emotional heartache.