Earnings Yield Research Articles

Financing Asset Growth

In this paper we provide new evidence that corporate financing decisions are associated with managerial incentives to report high equity earnings. Managers rely most heavily on debt to finance their asset growth when their future earnings prospects are poor, when they are under pressure due to past declines in earnings, negative past stock returns, and excessively optimistic analyst earnings forecasts, and when the earnings yield is high relative to bond yields so that from an accounting perspective equity is expensive. Managers of high debt issuing firms are more likely to be newly appointed and also more likely to be replaced in subsequent years. Abnormal returns on portfolios formed on the basis of asset growth and debt issuance are strongly positively associated with the contemporaneous changes in returns on assets and on equity as well as with earnings surprises. This may account for the finding that debt issuance forecasts negative abnormal returns, since debt issuance also forecasts negative changes in returns on assets and on equity and negative earnings surprises. Different mechanisms appear to be at work for firms that retire debt.

The Long-Run Relation between Returns, Earnings, and Dividends

We examine the predictive ability of the aggregate earnings yield for market returns and earnings growth by estimating a variance decomposition. Based on weighted long-horizon regressions for the 1946-2015 period, we find that most of the variation in the earnings yield is due to return predictability, with earnings growth predictability assuming a secondary role. However, by estimating a variance decomposition based on a first-order vector autoregression (VAR), we find that the major driving force is earnings growth predictability. We show that the share of earnings predictability implied from the VAR is due to a misspecification driven by the unusual high volatility in aggregate U.S. earnings during the recent financial crisis (2007-2009). Our results suggest that the practice of analyzing long-run return and cash-flow predictability from a VAR can be misleading, and reinforce previous evidence that what drives variation in aggregate price ratios is return (instead of cash-flow) predictability.

The “Fed Model” and the Predictability of Stock Returns*

The focus of this article is on the predictive role of the stock-bond yield gap--the difference between the stock market earnings (dividend) yield and the 10-year Treasury bond yield--also known as the Fed model. The results show that the yield gap forecasts positive excess market returns, both at short and long forecasting horizons, and for both value- and equal-weighted stock indexes, and it also outperforms competing predictors commonly used in the literature. These findings go in line with the predictions from a present-value decomposition. The absence of predictive power for dividend growth, dividend payout ratios, earnings growth, and future one-period interest rates, actually strengthens the return predictability associated with the yield gap at very long horizons. By performing an out-of-sample analysis, the results show that the yield gap has reasonable out-of-sample predictability for the equity premium when the comparison is made against a simple historical average, especially when one imposes a restriction of positive equity premia. Furthermore, the yield gap proxies generally show greater out-of-sample forecasting power than the alternative state variables. An investment strategy based on the forecasting ability of the yield gap produces significant gains in Sharpe ratios. Copyright 2013, Oxford University Press.

Style-Based Effects on the Johannesburg Stock Exchange: A Graphical Time-Series Approach

Fama and French (1992), in a controversial paper at the time, noted strong associations between cross-sectional equity returns and so-called style variables including size, the price to earnings (P/E) ratio, gearing and the book to market (B/M) ratio. Other researchers have subsequently identified further priced effects relating to (inter-alia): dividends, momentum, cash-flow and a January effect. Many of these have been identified on the Johannesburg Stock Exchange (JSE), (see: (Page & Palmer, 1991), (Page, 1996), (Plaistowe & Knight, 1987), (Fraser & Page, 2000), (van Rensburg, 2001) and (Mutooni & Muller, 2007)).We re-examine many of these styles using an improved methodology and data set. We find that portfolios constructed on the basis of univariate ranked style characteristics exhibit significant effects over the period 1985 to 2011. Most notably, we find significant and persistent excess returns in the following variables: momentum, earnings yield, dividend yield, price to book, cash-flow to price, liquidity, return on capital, return on equity and interest cover. Furthermore, we find no evidence of a size effect, except for fledgling companies.

The 'Fed Model' and the Predictability of Stock Returns

The focus of this paper is on the predictive role of the stock-bond yield gap - the difference between the stock market earnings (dividend) yield and the ten-year Treasury bond yield - also know as the Fed model. The results show that the yield gap forecasts positive excess market returns, both at short and long forecasting horizons, and for both value and equal-weighted indexes, and it also outperforms competing predictors commonly used in the literature. These findings go in line with the predictions from a dynamic accounting identity. The absence of predictive power over dividend growth, dividend payout ratios, earnings growth, and future one-period interest rates, actually strengthens the return predictability associated with the log yield gap at very long horizons. By performing an out-of-sample analysis, the results show that the yield gap has reasonable out-of-sample predictability over the equity premium, when the comparison is made against a simple historical average, especially when one imposes a restriction of positive equity premia. Furthermore, the yield gap proxies generally present greater out-of-sample predictability power than alternative forecasting variables. An investment strategy based on the forecasting ability of the yield gap produces significant positive certainty equivalent estimates for realistic levels of risk aversion.

The Relative Valuation of US Equities at Bear Market Bottoms: A Perspective on the Equity Risk Premium

We investigate stock returns, earnings growth, interest rates and the relative valuation of US equities following the 22 major bear market bottoms from 1881-2011. We find that large, sustainable bull market returns are associated with market bottoms where stocks' earnings yield expands significantly (as P/E ratios compress below average). Market bottoms since 1950 have been associated with shorter bear markets, lower average market earnings yields and slower real earnings growth following the market bottom, but higher real stock returns over the next 10 years. Since 1950, equity values have grown significantly faster than earnings, resulting in compression of the market earnings yield and stock-over-bond risk premium. Stock returns have become gradually disconnected from earnings to the point that the earnings yield is no longer reliably mean-reverting, and thus no longer predictive of future equity returns. Although we estimate the real equity risk premium to be only 0.5% below its post-1950 average, in the low-inflation, low-yield environment, US equities are priced to deliver below-average real returns of approximately 3.5% per year for the coming decade.

Composition of an efficient portfolio in the Bielecki and Pliska market model

We study the continuous time portfolio optimization model due to Bielecki and Pliska where the mean returns of individual securities or asset categories are explicitly affected by underlying economic factors. We introduce the functional Qγ featuring the expected earnings yield of portfolio minus a penalty term proportional with a coefficient γ to the variance when we keep the value of the factor levels fixed. The coefficient γ plays the role of a risk-aversion parameter. We find the optimal trading positions that can be obtained as the solution to a maximization problem for Qγ at any moment of time. The single-factor case is analyzed in more details. We present a simple asset allocation example featuring a Vasicek-type interest rate which affects a stock index and also serves as a second investment opportunity. Then we compare our results with the theory of Bielecki and Pliska where the authors employ the methods of the risk-sensitive control theory thereby using an infinite horizon objective featuring the long run expected growth rate, the asymptotic variance, and a risk-aversion parameter similar to γ.

The Fallacy of Price/Earnings to Growth Ratios

Price/earnings to growth (PEG) ratios are based on mathematics, but shockingly, the PEG ratio is only accurate under a very specific set of circumstances that are rarely ever met in the investment market place. Does the PEG ratio have any basis in reality and can you trust it? In our discussion, we offer case studies of Facebook and Extended Stay America and conclude that the PEG ratio is dangerous to use for businesses trading at high P/Es. Earnings growth rates simply cannot keep up with the high initial purchasing cost. In the Facebook example, if all other variables are held fixed, including the 10-year earnings growth rate, but you pay only 35 earnings, then the growth rate needed to break even is “only” 150.8%. For businesses with PEG ratios less than 1.0, caution rises in proportion to the magnitude of the P/E. The higher the P/E the more dangerous is the PEG ratio; and the danger rises exponentially, not geometrically. The PEG ratio breaks down in that it doesn’t account for the time value of money, makes no assumption for how to reinvest earnings, and doesn’t factor in the investment time horizon. What is the special case where the PEG ratio holds? The ratio holds when your desired rate of return and your earnings reinvestment rate are equivalent to the earnings yield of the business.

Understanding the Fed Model, Capital Structure, and Then Some

Twenty years after the papers by Modigliani and Miller, the introduction in 1982 of SEC rule 10b-18 fundamentally changed the rules of corporate finance, by allowing public companies open-market repurchases of their own stock and making it easier to manipulate capital structure. We present a new ‘capital structure substitution’ theory that is based on one simple hypothesis: company managements manipulate capital structure such that earnings-per-share are maximized. The substitution theory is used to reassess the ‘Fed model’, which describes the equilibrium observed between the average S&P 500 earnings yield (E/P) and the US government bond yield. We conclude that the Fed model is miss-specified: the S&P 500 earnings yield is not in equilibrium with the government bond yield but with the average after-tax interest rate on corporate bonds. The proposed theory also sheds new light on a variety of other phenomena observed in corporate finance. It is used to formulate a new theory on dividend policy, explaining why some companies prefer dividends over share repurchases and why dividend policy has changed in the early 1980s. It also provides a new explanation for the stock market’s reaction to monetary and fiscal policy. And it is used to explain why the positive relationship between leverage and beta, as predicted by Hamada, is not observed in market data.

Can Individual Investors Capture The Value Premium?

I test the performance of several simple one and two-factor mechanical GARP and value investment strategies against a value-weighted market portfolio for the period 1998-2006, focusing on the suitability of the strategies for individual investors. All of the GARP and value strategies produce substantially higher average returns than the market portfolio over the 97 rolling one-year holding periods included in the study. The strategies have a higher standard deviation of returns across the 97 start months, but are less likely than the market portfolio to experience negative returns over any three or five-year time period. Overall, the best performing strategies are EBIT to enterprise value and return on capital, EBIT to enterprise value alone, and earnings yield (the inverse of the P/E ratio). Adding a profitability factor to form a GARP strategy from a simple one-factor value strategy does not appear boost performance, though it does reduce risk in the EBIT to enterprise value and return on capital strategy. My results indicate that individual investors who are able to tolerate occasional underperformance should consider using a GARP or value strategy in at least a portion of the portion of their portfolio that is allocated to U.S. equities.

Aggregate Earnings and Expected Stock Returns in Emerging Markets

This paper examines the time-series predictability of aggregate stock returns in 20 emerging markets. In contrast to the aggregate-level findings in US, earnings yield forecasts the time-series of aggregate stock returns in emerging markets. We consider aggregate earnings not as normalizing variables for stock price but as predictive variables in their own right. Aggregate earnings themselves covary with the market returns, hence it is not just the mean reversion of stock prices that is responsible for the forecasting power of earnings yield. These results are robust across different estimation methods and after controlling for small sample bias and macroeconomic variables. We argue that due to high levels of fundamentals’ co-movement in emerging markets, the information content of firm-level earnings (unsystematic earnings) about future cash flows is not fully diversified away at the market level. Relevant literature shows that firm-level earnings are positively correlated with expected returns in US and this positive relationship remains significant only at the less diversified industry- level but disappears at the highly diversified US market level. Emerging markets are significantly less diversified compared to US. This explains the strong and robust predictive power of aggregate earnings in emerging markets.

The Equity Fear Premium and Daily Comovements of the S&P 500 E/P Ratio and Treasury Yields Before and During the 2007 Financial Crisis

The daily S&P 500 forward earnings yield (E/P ratio) is strongly negatively correlated with daily Treasury yields of all maturities during the 2007 financial crisis, which is a reversal from the relation that prevailed before the crisis. To explain this pattern reversal, I introduce a new risk measure called the Total Fear Premium that accounts for flight-to-safety and flight-to-liquidity behavior. The Total Fear Premium “mimics” the VIX during the financial crisis. Once the basic GARCH formulation modeling the interaction between the earnings yield and Treasury yields is augmented with the Total Fear Premium, the relation between the earnings yield and short-term Treasury yields becomes significantly positive, in line with Fama’s (1975) view that short-term yields are good proxies for expected inflation. Two by-products of this analysis are: 1) a new risk premium measure associated with flight-to-liquidity and 2) a new way to measure the inflation risk premium on a daily basis.

Reversion to the Mean, Taken to the Extreme

Mean reversion in stock prices has been associated with noise or ‘noise traders’ and on an aggregate level with the value effect. The mean reverting process has not only been observed in stock prices but also in reported earnings. A new cross-sectional equilibrium model is developed based on the observation that market aggregate price developments are positively related to earnings yield and market aggregate earnings developments are negatively related to earnings yield. As the two dependencies are close to linear, two coupled differential equations can be formulated and solved. The model shows that on average, portfolios with ‘value’ or ‘growth’ stocks will drift towards a mean valuation ratio. The time-dependent calibration shows that the speed with which portfolios have drifted towards earnings yield equilibrium has increased by almost a factor of 3 over the last 20 years. Market participants are doing an increasingly good job at predicting earnings developments, but the pricing of these earnings fluctuates over time. Data suggests that participation of ‘noise traders’ is strongly reduced after a market crash or strong bear market and builds up in the years after a crash. The model can be used by value investors as guidance for sector allocation and to optimize holding period.

Accounting Fundamentals and the Variation of Stock Price: Factoring in the Investment Scalability

This study develops a new return model with respect to accounting fundamentals. The new return model is based on Chen and Zhang (2007). This study takes into account theinvestment scalability information. Specifically, this study splitsthe scale of firm’s operations into short-run and long-runinvestment scalabilities. We document that five accounting fun-damentals explain the variation of annual stock return. Thefactors, comprised book value, earnings yield, short-run andlong-run investment scalabilities, and growth opportunities, co associate positively with stock price. The remaining factor,which is the pure interest rate, is negatively related to annualstock return. This study finds that inducing short-run and long-run investment scalabilities into the model could improve the degree of association. In other words, they have value rel-evance. Finally, this study suggests that basic trading strategieswill improve if investors revert to the accounting fundamentals.Keywords: accounting fundamentals; book value; earnings yield; growth opportuni­ties; short­run and long­run investment scalabilities; trading strategy;value relevance

Assessment of Relationship Between Stock Prices, Stock Earning and Yields of Government Participation Securities in Iran by the Fed Model

Stock exchange of securities is the major important way's optimal allocation and mobilization of capital in country and knowledge of this market and element and communications extant in it is considering one of important factor's capital market developments. The Fed model is a theory of equity valuation used by some security analysts that hypothesizes a relationship between long term treasury notes and the expected return on equities. According to this valuation model, in equilibrium the real yield on the 10-year U.S Treasury bonds should be similar to the S&P500 earnings yield (that is, S&P forward earnings divided by the S&P level). The Fed Model was so named by Ed Yardeni of Prudential Securities based on the fact that some research at the Federal Reserve in the late 1990s. Method used in Fed model for assessment relationship between stock price, income and long term bond yields is on econometrics methodology and based on cointegration framework. Regarded to importance of investment and its obtained yield, present research has dealing to reviewing relationship between stock price, stock earning and government bond yield (participation bond) in long time and by Fed model. In this study we use of stock exchange information and yearly reporting central bank in 6 and 12 yearly separate groups for long term investigating. The acquired results show that there is any cointegration or long term relationship in research variable and in other word yield of participation bond don't play any role in specification of stock price and yield of investment in stock exchange of securities. Note: Due to bonds prohibited in Islam, and have legal ban issuance of this bound in Iran, Islamic Republic of Iran issues a kind of bond that have some differences with bounds that issue in the world now (all differences expresses in whole paper). Issuance this kind of bond and their earning have no religiously problem in Islam.

Adjusted Earnings Yields and Real Rates of Return

An accurate forecast of real return requires that accounting and debt adjustments be made to reported earnings. This article presents methodologies that investors can use to estimate the accounting and debt adjustments for individual companies and offers evidence, derived from a predictive regression model, that investors should consider these adjustments important. The article also reviews the use of nonfinancial corporate debt and makes the case that investors should view the use of debt by nonfinancial companies more positively than they currently do.

Fundamentals of Stock Returns in Nepal

This study deals with fundamentals of stock returns in Nepal. It examines if dividend yield, capital gain yield and total yield are related to earnings yield, size, book to market ratio and cash flow yield. The study is based on pooled cross sectional data of 40 enterprises whose stocks are listed in Nepal Stock Exchange Limited and traded in the stock market. The study reveals that earnings yield and cash flow yield have significant positive impact on dividend yield, and an insignificant impact on book to market value. However, the size has a negative impact on dividend yield. In the case of earnings yield and cash flow yield, cash flow yield has been found to be more informative than earnings yield. Likewise, it is observed that capital gain yield is positively influenced by earnings yield and size, whereas, the same is negatively influenced by book to market value and cash flow yield. Book to market value has been found to be statistically strong in predicting capital gain yield. Similarly, it is noticed that total yield is positively determined by earnings yield and size, whereas, the same is negatively determined by book to market value and cash flow yield. Book to market value has been found to be more informative than other variables. The study also revealed the positive relationship among earnings yield, book to market value and cash flow yield. However, the size is negatively related to these three variables.

Returns to Buying Earnings and Book Value: Accounting for Growth and Risk

This paper documents that the earnings yield and book-to-price combine to predict equity returns in a way that is consistent with the rational pricing of risk. It is well known that earnings yields predict returns in the cross-section, consistent with standard formulas that show that the earnings yield equals the required return when there is no expected earnings growth beyond that from retention. With growth, those same formulas show that the earnings yield is increasing in the required return but decreasing in the growth. So, if growth is risky and requires a higher return, the determination of the required return from a given earnings yield is problematical. The paper shows that book-to-price facilitates the determination: for a given earnings yield, book-to-price indicates additional return associated with expected growth. The finding provides a rationalization of the well-documented book-to-price effect in stock returns: book-to-price indicates the risk in buying earnings and earnings growth. However, growth identified by a high book-to-price as yielding a higher return is quite different from “growth” typically attributed to a low book-to-price as yielding a lower return. Accordingly, the notion of “growth” versus “value” is redefined.

Oil and gas—winners and losers of the credit crunch

Since mid 2007, we have seen one of the biggest crises ever to hit the financial markets—the so-called credit crisis. Initially banks bore the brunt of the credit crisis, but the ramifications were far deeper, affecting consumer households as well as debt and equity reliant organisations. This presentation will discuss the specific impacts of the crisis for the oil and gas industry, including: the fact that it is not just a credit crunch, but also an equity crunch; the fact that the issues in raising debt capital—the cost is now well beyond the global earnings yield; the fact that investors are now seeking alternate, less risky and less complicated investment options; and the fact that investment funds are shifting from private equity funds to oil-financed sovereign wealth funds. The crisis has had varying impacts on the oil and gas industry. Organisations reliant on debt and equity funding and those operating in new or start-up ventures are under increased pressure and scrutiny. On the other hand, well positioned oil and gas organisations can take advantage of current and emerging opportunities, particularly in relation to alternate energy sources. In the future, financial prosperity will be with organisations that operate in countries with guaranteed supplies of oil and gas (e.g. Australia, Brazil, Russia, India and China). A future focus for the oil and gas industry will be for organisations to maintain very disciplined and robust financial-risk management systems in order to manage their liquidity and financial risks in this changed environment.

The FED Model and Expected Asset Returns

The focus of this paper is on the predictive role of the stock-bond yield gap - the difference between the market earnings yield and the ten-year Treasury bond yield - also know as the FED model, and which can be interpreted as a long-term yield or return spread of equities relative to bonds. Conditional on other forecasting variables, the yield gap forecasts positive excess market returns, both at short and long forecasting horizons, and for both value and equal-weighted indexes. On the other hand, the yield gap forecasts negative excess returns for bonds, at both short and long horizons. These findings go in line with the predictions from a dynamic accounting identity. By performing an out-of-sample analysis, the results show that the yield gap has reasonable out-of-sample predictability over both stock market and long-term bond returns, when the comparison is made against both a simple historical average and an autoregressive specification. Furthermore, the yield gap proxies have greater out-of-sample predictability power than alternative forecasting variables. An investment strategy based on the forecasting ability of the yield gap produces higher Sharpe ratios than passive strategies in both the market index and long-term bond, and in addition, the certainty equivalent estimates are in general positive.