DEFINITION of 'Bond Equity Earnings Yield Ratio - BEER'

The Bond Equity Earnings Yield Ratio (BEER) is a metric used to evaluate the relationship between bond yields and earnings yields in the stock market. BEER has two parts – the numerator is represented by a benchmark bond yield, such as a five- or 10-year Treasury, while the denominator is the current earnings yield of a stock benchmark, such as the S&P 500.

BEER = Bond Yield / Earnings Yield

The Bond Equity Earnings Yield Ratio is also known as the Gilt-Equity Yield Ratio (GEYR).

BREAKING DOWN 'Bond Equity Earnings Yield Ratio - BEER'

Comparing the yield on long-term government debt and the average yield on an equity market benchmark can be used as a form of indicator on when to buy stocks. Investors use the movement in bond yields to determine the direction of the stock market by using a ratio known as the Bond Equity Earnings Yield Ratio, or BEER.

BEER is calculated by dividing the yield of a government bond by the current earnings yield of a stock benchmark in the same market. The current earnings yield of the stock market (or simply an individual stock) is just the inverse of the price-to-earnings (P/E) ratio, that is, earnings/price. The earnings yield is quoted as a percentage, which measures the percentage of each dollar invested that was earned by a company, sector, or the whole market during the past twelve months. For example, if the P/E ratio of the S&P 500 is 25, then the earnings yield is 1/25 = 0.04. It is easier to compare the earnings yield to bond yields than to compare the P/E ratio to bond yields.

The theory behind the ratio is that if stocks are yielding more than bonds, that is, BEER < 1, then stocks are cheap given that more value is being created by investing in equities. As investors increase their demand for stocks, the prices increase, causing P/E ratios to increase. As P/E ratios increase, earnings yield decreases, bringing it more in line with bond yields. Conversely, if the earnings yield on stocks is less than the yield on Treasury bonds (BEER > 1), the proceeds from the sale of stocks is reinvested in bonds. This results in a decreased P/E ratio and increased earnings yield. Theoretically, a BEER of 1 would indicate equal levels of perceived risk in the bond market and the stock market. Analysts often feel that BEER ratios greater than 1 imply that equity markets are overvalued, while numbers less than 1 mean they are undervalued, or that prevailing bond yields are not adequately pricing risk. If the BEER is above normal levels, the assumption is that the price of stocks will decrease, thus, lowering the BEER.

Consider a 10-year Treasury with a yield of 2.8% and earnings yield on the S&P 500 of 4% (P/E of 25). The BEER ratio can be calculated as:

BEER = Bond Yield (0.028) / Earnings Yield (0.04) = 0.7

Using the results above, an investor can conclude that the stock market is undervalued as the ratio falls below 1.

The Bond Equity Earnings Yield Ratio helps investors understand the value created by investing one dollar in bonds versus investing that dollar in stocks. However, critics have pointed out that the BEER ratio has zero predictive value, based on research that was carried out on historical yields in the Treasury and stock markets. In addition, creating a correlation between stocks and bonds is said to be flawed as both investments are different in a number of ways - while government bonds are contractually guaranteed to pay back the principal, stocks promise nothing. Similarly, unlike the interest on a bond, a stock’s earnings and dividends are unpredictable and its value is not contractually guaranteed.

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