Which one controls for Inflation?

CFA Level III
#1

FED, Yardeni or P/MA(E) ?

#2

P/MA(E).

#3

Fed = (E1/P)/Long term Government Bond yield

Numerator is adjusted for Inflation (it is a real variable ratio of current earnings to current prices). Denominator is Nominal Bond yield - not adjusted for Inflation. [Compares a real variable with a nominal variable)

Not answering question asked - but just to get things all in one place…

  • Fed Model ignores Equity Risk premium.
  • Ignores Earnings growth opportunities for Equity holders beyond the next period.

If above ratio < 1 - Equity Market is OVERVALUED. (E1/P < Bond Yield)

If above ratio > 1 - Equity Market is UNDERVALUED. (E1/P > Bond Yield).

Yardeni = (E1/P) / (A Rated Corp Bond Yield - d * LTEG)

How does this resolve issues in the Fed Model?

  1. Includes a LTEG component for Equities.

  2. Captures a Risk premium - but it is not exactly an Equity Risk Premium.

If Ratio < 1 - Undervalued, Ratio = 1 Fairly Value, > 1 = Overvalued Equity Market.

Snice A-rated Corporate Bond yields are used in the denominator (and not Treasury Bonds) - Inflation is included.

P/MA(E)

Both Numerator (1o year average price) and denominator (Moving average of earnings over 10 years) are REAL. So this includes impact of inflation.

#4

Thanks cp, I just hope you are not typing all the above ^

#5

good stuff cpk

#6

Correct. Except the P in P/MAE is not the average price. It is the real price on that date divided by the previous 10 years averag earnings. No average in the price.

#7

thanks cpk

#8

hey CPK,

thanks for the detailed explanation. However I have question regading valuing market in yardeni. In CFAI volume 3 page 160 it states "A justified forward earnings yield that is below , equal to, or greater than the forward earnings yield implied by the current equity market index values…would indicated that equities are undervalued , fairly valued, or overvalued in the marketplace. "

so if market yield > yardeni yield --> undervalued equity

if market yield < yardeni yield --> overvalued equity

what ya think?

#9

My bad.

Ratio = (E1/P)/(Yb - d* LTEG)

Yes. Justified Forward Earnings Yield = yb - d * LTEG.

If E1/P < yb - d * LTEG – Ratio < 1 - then OVERVALUED.

Ratio > 1 UnderValued

Ratio = 1 Fairly Valued.

Thanks for pointing it out.

#10

It is easy to remember this way.

Yield is higher when P is lower. So when market yield >Yardeni, market is undervalued.

#11

yep, Yardeni earnings’ yield is a fair earnings yield.