Most of us have heard the saying, “Comparison is the root of all unhappiness.” And I would agree…most of the time.
However, when it comes to BEER and investing, I would have to disagree. More on this in just a minute. First things first.
Investing really boils down to opportunity costs.
Opportunity cost: is the potential benefit or gain that is given up when an individual or organization chooses one course of action over another. It is the value of the next best alternative that must be forgone in order to pursue a certain action. Opportunity cost is a key concept in economics and decision-making. It helps individuals and organizations weigh the costs and benefits of different choices and make the most efficient use of resources (time and money).
Opportunity costs should be considered in the context of your priorities and goals.
In terms of investing, let’s use this idea of opportunity cost to evaluate investment options…and that’s where BEER comes in.
Before we get to BEER, let’s quickly talk about what’s called “Earnings Yield.”
Earnings yield is a measure of the profitability of a company or index when compared to the price being paid. The earnings yield is calculated by dividing the EPS (earnings per share) of the index by the current price. It is the inverse of the well-known P/E ratio. In the simplest terms and all else being equal, the higher the earning yield the better.
The power of the earnings yield is the ability to use it as a comparison tool…and now that’s where BEER comes in.
BEER stands for Bond Equity Earnings Yield Ratio.
The bond equity earnings yield ratio (BEER) is a tool that can be used to evaluate the relationship between bond yields and the earnings yield in the stock market.
BEER has two parts, the numerator is represented by a benchmark bond yield, such as the two, five, or ten-year Treasury Bond, while the denominator is the current earning yield of a stock benchmark.
A comparison of these two numbers can be used to get an idea if bonds or stocks are more attractive relative to each other. The idea behind the BEER ratio is that if stocks are yielding more than bonds, then they are undervalued; inversely, if bonds are yielding more than stocks, then stocks are overvalued.
For example, if the P/E ratio of the S&P 500 is 18, then the earnings yield is 1/18 = 0.056 or 5.6%. And it is easier to compare this number to bond yields than to compare the P/E ratio to bond yields.
Some investors believe if the ratio is above 1.0 the stock market could be said to be overvalued; a reading of less than 1.0 indicates the stock market is undervalued relative to bonds.
BEER Highlights
- The bond equity earnings yield ratio (BEER) is a way for investors to compare stocks vs. bonds.
- The ratio is determined by dividing the yield of a government bond by the current stock market earnings yield benchmark.
- A ratio greater than 1.0 could indicate the stock market is overvalued, while a rating of under 1.0 suggests stocks might be undervalued relative to each other. Looking at the ratio over time can be helpful as well.
- The S&P 500 Earnings Yield can also be used to gauge the overall health of the stock market. A high earnings yield indicates that the stock market is undervalued, while a low earnings yield indicates that the market is overvalued. This information can be useful for investors making investment decisions.
Limitations of BEER
- US Treasury bonds are considered risk free while stock investing is not. So it’s not exactly an apples-to-apples comparison.
- Bond interest is contractual while stock earnings and dividends are not. A company’s earnings are unpredictable.
- Earnings yield is only one factor to consider when evaluating a company’s stock. Other important factors include the company’s growth prospects, industry trends, and management team.
- Changes in interest rates affect the earnings yield and bond yields and many times not in a linear fashion. S&P 500 earnings yield can fluctuate over time. Economic conditions, such as recessions or expansions, can have a significant impact on the earnings yield.
It’s important to understand that BEER is not a standalone measure, and it’s important to consider other factors such as economic conditions, company performance, and overall market sentiment when making investment decisions.
BEER can be a useful metric for comparing the relative value of bonds and stocks. It can be used to help investors make decisions about how to allocate their investments between the two asset classes. However, it is not a standalone measure, and other factors must be considered when making investment decisions.
So go enjoy a nice cold beer as you use BEER to help you make more informed investment decisions.
-Paul R. Rossi, CFA