Yield is the money you make on your investments. Different investments have different names for yield. If you own a farm, the crops you harvest each year which you can then convert into cash is the yield on your farm. If you own a rental property, the rent you receive is your yield on that property. Financial assets like stocks and bonds have their own version of yield. Bonds pay interest whereas stocks pay dividends. That is their yield.
Income from financial assets is more passive whereas you have to put in some work to generate yield from say a farm or a rental property.
And quite naturally, the riskiness of the yield is different for different investments. Yield from government bonds is the safest which makes sense because governments don’t go bankrupt. Dividends from stocks are riskier because businesses do go bankrupt. Farms and rental real estate have their own risk dynamics like a harvest going bad or a tenant not paying rent. We’ll continue the rest of the discussion using financial assets only though the underlying yield theory applies to all types of investments.
So about the riskiness of yield and because businesses can go bankrupt, you’d expect more yield from stocks than safe government bonds or else why would you own stocks. The difference in yield between the two is called the equity risk premium. It compares the yield on 10-year government bonds to the earnings yield of stocks or better yet, the stock market. In America, a convenient proxy for the stock market is the S&P 500 index. For Japan, it is the Nikkei. For India, it is the BSE Sensex and so on.
ERP = E/P – Y
ERP is the equity risk premium
E/P is today’s earnings yield for stocks (inverse of P/E or the price to earnings ratio)
Y is the yield on 10-year government bonds
Every county has its own equity risk premium. We can even define equity risk premiums for categories of stocks like for large cap stocks or small cap stocks or biotech stocks but in general and rightly so, ERP applies to the broader stock market.
But why compare the stock market yield to a 10-year bond yield? Why not to say a 1-year bond yield or to say a 30-year bond yield? Not comparing to a 1-year bond yield is clear. Stocks are long-term investments so comparing them to investments that are short-term in nature does not make sense. Stocks in fact are perpetuities which technically mean that they are expected to deliver yield (dividends) forever.
Then why not compare yield on stocks to say a 30-year bond yield or to an even longer duration bond yield? Good question and I say why not. I’d ideally compare the stock market yield to the yield on the longest duration safe investment but the 10-year bond has sort of become a benchmark investment to compare all long-term investments against.
And to some extent it makes sense. The premise is that the price of a stock today reflects the past and the future assuming no additional investments are made in the business behind that stock. But to grow that business and hence its stock price, new investments will need to be made or soon enough, whatever it has to offer its customers would go stale and that business can go out of business. Think Apple not changing anything after the first version of iPhone they launched. If there were no improvements made to that phone since then, no one would buy an iPhone today.
So when new projects are being considered by a business to invest in, the 10-year bond yield is usually the hurdle rate used to make a go or no-go decision on those projects. And 10 years is a decent amount of time where the fruits of those investments start to show up on a business’s bottom-line.
So back to the equity risk premium, say that the 10-year government bond is yielding 5%. How does that compare to stocks? We compare that with the earnings yield for stocks and we get the earnings yield by inverting the price to earnings ratio as discussed before. So if the stock market P/E is 20, its earnings yield (E/P) is 5%.
Hmm, then why would you own stocks? Because the E in E/P grows. Earnings can also decline and hence the risk with stocks but over time, for a basket of stocks, it grows. So when you hold stocks for the long-term, the earnings yield keeps growing because the profits (earnings) keep growing.
Why do earnings have to grow? Part of that growth is due to inflation. Businesses don’t absorb the cost of rising prices and instead pass them down to their customers. Businesses that cannot raise their prices fade away with stronger businesses with pricing power taking their place so the composite earnings for the stock market which represents a wide variety of businesses should continue to keep pace with inflation.
So,
Er = E/P + i
Er is the expected rate of return for stocks
E/P is today’s earnings yield for stocks as discussed before
i is the inflation rate
But historical stock market earnings have grown at a rate faster than the rate of inflation. Where does that additional growth above inflation come from? It comes from reinvestment of the profits a business makes. Because when a business earns profits, it can decide to retain all those profits on its books and not do anything with it.
Or it can deliver all the profits it earns as dividends to its shareholders. If it does that, there is no money left in the business to invest in R&D to develop new products or to explore new avenues for growth. That may work for sometime until competition comes along and eats into whatever profits that business used to make and the business eventually dies. Think back to the iPhone example.
So instead, most businesses retain some of the profits for reinvestment while distributing the rest as dividends to its shareholders. The percent of profits (earnings) that is paid out as dividends is called the payout ratio1.
Introducing hence, a few more terms to the expected return calculation for stocks…
Er = (Pay x E/P) + i + g
Er is the expected rate of return for stocks
Pay is the percent of earnings that is paid out as dividends
E/P is today’s earnings yield for stocks
(Pay x E/P) is today’s dividend yield
i is the inflation rate
g is the growth in earnings over and above the rate of inflation that materializes due to the reinvestment of profits a business retains
And that last term g is where the magic happens. A lot of the progress we see around us is because of g which is an outcome of the capital allocation decisions businesses in aggregate make in our global economy.
So just comparing the stock market yield with the 10-year government bond yield when estimating the equity risk premium misses a couple important elements of why stocks in the long run should outearn bonds. The first among them is the fact that profits in aggregate for a basket of stocks grow with inflation. Interest income for bonds does not.
And the second reason why stocks outearn bonds comes with reinvestment of the retained profits at a rate over and above the rate of inflation. This reinvestment process adds an extra layer of growth that not only makes the stockholders rich but also enriches all our lives as new products get developed, as new cures for diseases are discovered and as progress marches on.
Thank you for your time.
Cover image credit – Noel McShane, Pexels
- Fight the Fed Model by Cliff Asness of AQR Capital Management writing in The Journal of Portfolio Management, Fall 2003 ↩︎