is the inverse of the price-earnings ratio, and it would be the current
yield on a stock if all earnings were paid out as dividends.^25
Since the underlying assets of a firm are real, the earnings yield is a
real, or inflation-adjusted, return. Inflation raises the prices of the output
and hence the cash flows from the underlying assets. As a result real as-
sets tend to rise in value when the price level increases. The increasing
cash flow from equities contrasts to the fixedreturn earned from bonds,
where the coupons and the final payment are fixed in money terms and
do not rise with inflation.
The long-run data certainly bear out this contention. As noted
above, the average historical P-E ratio has been 14.45, so the average
earnings yield on stocks has been 1/14.45, or 6.8 percent. This earnings
yield is virtually identical to the 6.7 percent real return on equities from
1871 taken from Table 1-1.
When using the earnings yields to predict forward-looking real re-
turns, it is advisable to take some average of past earnings to smooth out
temporary increases and decreases in earnings that may be due to such
factors as the business cycle. The earnings yield based on a five-year av-
erage of past earnings against the next five years of real returns is plot-
ted in Figure 7-3.
Although there is significant noise in the data, the plot does show a
significant relation between earnings yields and subsequent returns. The
very high earnings yields (and low P-E ratios) of over 0.2 were associ-
ated with the highest subsequent five-year returns, while the two lowest
earnings yields (and highest P-E ratios) of 0.0291 and 0.0293 are associ-
ated with low subsequent returns. Almost one-quarter of the subsequent
five-year returns can be explained by the earnings yields.
But one must be very careful about using a historical average of
earnings. Although such a procedure will remove some of the cyclical
bias in the data, it is not robust to changes in dividend yield policy. As
noted in Chapter 3 in discussing the trend line of the Dow Jones Indus-
trials, and as will be discussed in the next chapter, a change in dividend
policy will change the rate of earnings growth so that average earnings
yields are not directly comparable. A fall in the payout ratio, which ac-
celerates capital gains, will lead to an underestimateof future real returns
if an average of past earnings is used.
112 PART 2 Valuation, Style Investing, and Global Markets
(^25) If all earnings are not paid as dividends, then the return on the stock will be the sum of the divi-
dend yield plus the capital gain, which, under the assumptions about the invariance of the value of
the firm to the dividend policy noted earlier, will equal the earnings yield on the stock.