Geoff Gannon September 28, 2010

Bonds: Interest Rates and Asset Prices – What’s the Right Earnings Multiplier?

Here’s a follow-up question from a reader who’s still troubled by the idea of multiplying a stock’s 10-year average earnings by the inverse of AAA bond yields to estimate the stock’s intrinsic value:

Suppose bonds yielded 0%. That would imply an infinite valuation for companies…What is the price-to-coupon multiplier you would use at an extreme?  Say bond yield of 0%, 1%, etc.    

You’re focused on bond yields instead of bond prices. Saying assume 30-year AAA corporate bonds yielded 1% is like saying assume stocks traded at a P/E of 100 or farmland sold for $50,000 an acre. Can you do math with those numbers? Sure. Can you see them in the wild? No.

I use 30-year AAA corporate bonds instead of government bonds. Their lowest yield was 2.53% in 1946. That means a multiplier of 39.53.

For 1881-2010 the multiplier range is 7 to 40. Meanwhile: the price to 10 year average earnings for stocks ranged from 5 to 43. Investors have never valued $1 of earnings at less than $5 or more than $43. Nor have they valued $1 in promised AAA cash at less than $7 or more than $40.

To have 1% 30-year AAA corporate bond yields, you’d need to push the price of those bonds up from a historical median price of $21.72 per $1 promise to $100 per $1 promise. That’s a 360% price increase.

It would look like this:

If that happened, I’d buy stocks. I’d be too scared to buy bonds. Wouldn’t you?