What Is the 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.
A comparison of 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. If the ratio is above 1.0 the stock market is said to be overvalued; a reading of less than 1.0 indicates the stock market is undervalued.
The bond equity earnings yield ratio may also go by the gilt-equity yield ratio (GEYR).
The Formula for BEER Is
BEER=Earnings YieldBond Yield
How to Calculate 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.
What Does BEER Tell You?
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 are 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.
- 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.
- A ratio of greater than 1.0 indicates the stock market is overvalued, and under 1.0 stocks are undervalued.
- A particular example of a BEER using the S&P 500 and 10-year Treasuries is the so-called Fed model.
Example of How to Use BEER
Consider a 10-year Treasury bond with a yield of 2.8% and the earnings yield on the S&P 500 at 4% (indicative of a P/E of 25x). The BEER ratio can thus 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 is calculated to be below 1.0.
The Difference Between BEER and the Fed Model
The Fed model is a particular case of a bond equity earnings yield ratio. A BEER ratio can be calculated using any benchmark bond yield and any benchmark stock market's earnings yield. The Fed model is a tool for determining whether the U.S. stock market is fairly-valued at a given time. The model is based on an equation that compares the earnings yield specifically of the S&P 500 with the yield on 10-year U.S. Treasury bonds.
Economist Ed Yardeni created the Fed model. He gave it this name saying it was the "Fed's stock valuation model, though no one at the Fed ever officially endorsed it." The Fed model dictates that if the S&P’s earnings yield is higher than the U.S. 10-year bonds yield, the market is "bullish."
A bullish market assumes stock prices are going to rise and a good time to buy shares. If the earnings yield dips below the yield of the 10-year bond, the market is considered "bearish." A bearish market assumes stock prices will decline. The Fed model did not seem to work during and following the 2008 financial crisis. The widely used and accepted model still has many investing experts questioning its utility in recent years.
Limitations of BEER
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.