Yardeni (2000) developed a model that incorporates the expected growth rate in earnings—

a variable that is missing in the Fed Model.28 Yardeni’s model is

where CEY is the current earnings yield on the market index, CBY is the current Moody’s Investors Service A-rated corporate bond yield, and LTEG is the consensus five-year earnings growth rate forecast for the market index. The coefficient b measures the weight the market gives to five-year earnings projections. (Recall that the expression for P/E in terms of the Gordon growth model is based on the long-term sustainable growth rate and that five-year forecasts of growth may not be sustainable.) Although CBY incorporates a default risk premium relative to T-bonds, it does not incorporate an equity risk premium per se. For example, in the bond yield plus risk premium model for the cost of equity, an analyst typically adds 300–400 basis points to a corporate bond yield.
Yardeni found that, prior to publication of the model in 2000, the coefficient b had averaged 0.10. In recent years, he has reported valuations based on growth weights of 0.10, 0.20, and 0.25. Noting that CEY is E/P and taking the inverse of both sides of this equation, Yardeni obtained the following expression for the justified P/E on the market:

Consistent with valuation theory, in Yardeni’s model, higher current corporate bond yields imply a lower justified P/E and higher expected long-term growth results in a higher justified P/E.

Transcribed Image Text:

CEY CBY-bx LTEG + Residual