Arguably bond investors are more logical and technical in their approach than many equity investors. This reflects the mathematical disciplines required to analyse fixed income markets whereas the greater uncertainties prevalent in the equity space is in keeping with a slightly more artistic bent. This is reflected in the key valuation metrics used by the respective camps.
Bond investors use yields to assess the merits of individual bonds, in contrast equity investors often focus on p/e ratios to compare valuations. The two metrics are of course connected, inverting the p/e ratio generates a yield or more specifically, the earnings yield. What is less appreciated is that there is a non linear relationship between p/e ratios and the earnings yield. For example, the chart below illustrates that a single point shift in p/e ratio from 9 to 10, represents a greater change in earnings yield than a shift from 19 to 20.
It strikes me that earnings yield is a far more intuitive and meaningful concept than p/e ratios. Yet, p/e ratios remain a ubiquitous valuation metric for equity investors – I can only assume that this is for historical reasons.
One interesting post script to this is that bond yields can be converted into p/e ratios. A 1.5% gilt yield, broadly where the 10 year note currently trades, converts to a p/e ratio of 66x! For equity investors, this is entering into ‘nose bleed’ territory and only appropriate for rapidly growing companies with huge profit growth potential. Yet the coupons on conventional gilts are fixed and will never climb. This seems to be an enormous price to pay to obtain the certainty that gilts deliver.
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