Geoff Gannon December 27, 2006

On the Dow’s Normalized Earnings Yields for 1935-2006

Before tackling the subject of what kind of returns investors can expect from the stock market over their lifetime (and what a “fair” value for the Dow might be) we need to put today’s valuations in historical perspective.

To do this, I will first provide a graph of the Dow’s 15-year normalized P/E ratio for each year from 1935-2006. For information on how these “normalized” numbers were calculated, please see my previous post “On Calculating Normalized P/E Ratios.”

PE ratio.jpg

I consider this graph to be something of a conceptual crutch. Everyone cites P/E ratios – even I do, because it’s one of the best known measures in investing. Regardless of the audience you’re writing for, you can count on them understanding the P/E ratio.

However, presenting P/E ratios is a bit misleading, because I don’t really think in terms of P/E ratios – I think in terms of earnings yields. You should too.

The earnings yield is a much easier number to work with. It facilitates comparisons with other possible investments, simplifies the process of estimating the expected rate of return over various holding periods, and just generally makes life a whole lot easier.

The earnings yield is simply the inverse (i.e., reciprocal) of the P/E ratio. Simply put, it’s “e” over “p”. For example, a stock with a price-to-earnings ratio of 12.5 has an earnings yield of 8%.

Here is a graph of the Dow’s 15-year normalized earnings yield for each year from 1935-2006:

Earnings Yield.jpg

Finally, to give you an idea of the role interest rates played during this period, here is a graph showing both the Dow’s normalized earnings yield and AAA corporate bonds yields for each year from 1935-2006:

Earnings Yield AAA.jpg

Just look over these graphs for now. I’ll discuss the importance of normalized earnings yields in my next post. Without some historical perspective, you may have trouble following that discussion.

Related Reading

On 15-Year Normalized P/E Ratios for the Dow

On Normalized P/E Ratios and the Election Cycle

On Normalized P/E Ratios and the Election Cycle (Again)

On Normalized P/E Effects Over Time

On Calculating Normalized P/E Ratios

On the Difference Between Actual Earnings and Normalized Earnings

I’ll have many more posts on this project in the days ahead. If you have any questions (or suggestions) about this project, please feel free to comment to this post – or, simply send me an email.