That's a question, and not a rhetorical one. I can think of a reason why it would be understated. But I lack the practical knowledge of corporate accounting to know if my reasoning is correct in practice, or if there's some offsetting effect I'm ignoring, and if the effect I'm talking about is big enough to matter.
This is a response to Felix Salmon's chart (originally from economic historian James MacDonald) comparing the S&P 500 earnings yield to the BAA bond yield since 1920.
Here's a simple example to explain what I'm talking about.
A corporation buys farmland at $1,000 per acre, and rents it out at $30 per acre per year. It uses 100% equity finance (it issues only stocks, and no bonds). It has no other assets or expenses. So, if the stocks trade at book value, they would have an earnings yield of 3%.
But suppose there's 2% inflation in this economy. And assume that everything rises at that same 2%, including land prices and land rent. Ignoring risk, what asset would give the better rate of return: stocks in that corporation; or bonds (issued by some other corporation) yielding 5%?
I would say that the two assets have the same yield, and investors should be indifferent between the two. Since the present value of the rents is rising at 2% per year, and the underlying assets are rising at that same 2% per year, the stock price should also be rising at the same 2% per year, even if nothing else changes.
In a world of 2% inflation across the board, a stock that reflects ownership in real assets has a true nominal earnings yield of 5% rather than the reported 3%. The same as the bonds that have a 5% nominal earnings yield, so the investor should be indifferent between the two assets. Accountants do not include the (nominal) capital gains on farmland (or the rising nominal present value of the rents) as part of the corporation's earnings, so the earnings yield on shares will seem to be lower than the earnings yield on bonds.
Or, we can measure yields in real (inflation-adjusted) terms instead. The real yield on the shares is 3%. But the real yield on bonds is the nominal 5% minus 2% inflation, which is 3% real. Again, an investor should be indifferent between stocks and bonds.
Now take a second corporation, exactly like the first, except it uses a more realistic 60%-40% mix of debt- and equity-finance. It issues $600 of bonds and $400 of stocks to buy 1 acre of farmland at $1,000. So it earns $30 rent, pays 5%x$600 = $30 interest, and has earnings after interest of $0. So the earnings yield on its stocks would appear to be 0%. Which compares very badly with the 5% yield on bonds. But after accounting for inflation, the real interest paid is only 3%x$600, which is $18 per year. So its real earnings after real interest are $30-$18 = $12 per year. And that gives its stocks an earnings yield of $12/$400 = 3% real. Which is exactly the same as the 3% real yield on bonds.
Put it another way. if a corporation has real assets, and uses a mix of debt and equity finance, the value of the shareholders' assets, net of the debt, should be rising even faster than inflation in nominal terms. We shouldn't just add the inflation rate to the earnings yield on stocks, if we want to compare it to bonds. We should add some multiple of the inflation rate. Like (60/40) x inflation.
If the corporation is a bank, it's different. Because banks have (mostly) nominal assets, like mortgages and government bonds, rather than real assets like farmland.
If the corporation has real assets like machines, that wear out and depreciate over time, rather than something like farmland, it may be different again. I can't get my head around how depreciation and inflation interact given standard accounting practices in measuring earnings.
My personal rule of thumb: add 2% to the stock earnings yield before comparing it to bonds. Except for banks. (Is this roughly right?)
Morals:
1. Inflation confuses people, even intelligent well-informed people. Even economists. It's the old "Yardstick that gets shorter over time" problem.
2. I wish accountants could adjust everything for inflation. In principle, it ought to be so easy. Since we money/macro types really don't want to target 0% inflation (for reasons I won't go into here), it's up to the accountants to adjust their methods of measuring things. Yes, it can be done. Just stop thinking a dollar is a dollar. It isn't. If there's 2% inflation, a 2011 dollar is worth 98 cents in 2010 dollars.
Worthwhile Canadian Initiative 
“OK, but suppose the earnings were in one money and the debt was in another (e.g. a foreign currency). And then the exchange rate changed, so the debt was worth less in domestic currency. Would accountants record a profit from the lower value of the debt? It’s rather like that when there’s inflation.”
Under Canadian GAAP I think they would record an F/X gain at year end (although, for tax purposes, no gain is generally realized, at least on capital account debt, until it is repaid). And while I agree that the economic effect is identical to inflation, the accounting treatment wouldn’t be the same, because there’s be no adjustment for the declining real value of your liabilities caused by inflation (conversely, for tax purposes, you also wouldn’t report a gain, even though economically you’ve realized one – inflation isn’t always a bad thing for tax purposes).
RSJ: You want to make the debts “real”, so that inflation causes the firm’s nominal obligations to go up — but it doesn’t. Only a renegotiation/roll-over of those obligations can cause them to change, in an economy in which money is the unit of account. And note that even though “inflation” is a convenient term, it varies significantly from geographic area to area, from type of good (oil/non-oil commodity/etc), and from person to person.
Nick is making the debts “real”, and I confess, I had the same problem with that. But I don’t think he’s out of line in doing so, provided that he’s assuming that interest isn’t paid annually, but rather compounds over time and is only paid at maturity. Under that assumption, in an environment with 2% inflation, a $1000 bond with a 5% annual interest rate, would be equivalent to a bond with “real” principal amount of $1000 paying a 3% annual interest.
You’re point about the variability of what constitutes inflation is a good one though, which is probably why accountants don’t try to adjust accounting records for it in the same way they do foreign exchange gains or losses.
I think Nick is asking the following question:
When building a cashflow valuation model for a company, is it reasonable to assume that earnings will remain constant or should they be increased with inflation?
Current accounting earnings give us (imperfect) information on what current earnings are but we don’t know what future earnings will be. Market tells use the value of those future earnings, but not the yield (we need to know the actual future flows to calculate that). We need to guess… Once we guess and calculate the yield, we can compare it with yields for other investments and decide what to buy.
Repeating my arguement, I think that guessing constant dollar earnings is a bad guess since it will imply ever decreasing corporate profits as a percentage of GDP.
There are many equity relative value models.
A common approach is to calculate a market-wide earning growth rate by inferring it from some ratio of historical earnings and current market cap. That market earning growth rate is used to forecast future flows company by company and to calculate a valuation metric. This makes sense when scoring different equities but doesn’t really help when pricing equity vs credit vs govies.
Personally I look at four numbers: earning yield, cds yield, nominal gov yields, real gov yields.
I think of the following:
earning yield = real gov yield + cds yield + equity premium
I compare each number vs its historical average and pick the exposures I like… For euro I pick germany as the gov (and view other govies as corporates really)…
acarraro: this is what Nick originally asked: “Put it another way. if a corporation has real assets, and uses a mix of debt and equity finance, the value of the shareholders’ assets, net of the debt, should be rising even faster than inflation in nominal terms. We shouldn’t just add the inflation rate to the earnings yield on stocks, if we want to compare it to bonds. We should add some multiple of the inflation rate. Like (60/40) x inflation.”
My point is, that this nominal increase should already be calculated into the price of stocks. So if for example analysts predict that asset value of a company will steadily rise during next 10 years (let’s say the company owns a forrest that in 10 years will be ready to be harvested) and that during that time shareholders may expect 0 dividend, then such increase should be reflected in the price of stocks. So for example if you predict the forrest will have value of $1629 in 10 years and that company is fully financed by shares of current worth $1000 (no bonds) then you expect nominal yield of 5% a year.
Or in other way, in order for a company to induce shareholders to buy its shares, it has to offer them such current price of shares as to be competitive with bonds.
I agree that the value of earnings growth (and not just nominal but real as well) is built in the stock price. We are not discussing the value, but the yield. You need more information to calculate the yield (as I said above).
If you believe in efficient markets, the yield is useless since it will be the best forecast you can make (and it doesn’t matter what you invest your money in anyway, you just need to leverage to get your target risk).
If you don’t, the yield will give you a (I think better) statistic to decide how to invest.
In your example you forecast a value for the forest. In the same way you need to forecst the value of future earnings (and observe current price) to get the yield.
I think a reasonable forecast is that earnings will increase in line with inflation.
Georgioz: “My point is, that this nominal increase should already be calculated into the price of stocks.”
Indeed it should be. Agreed. But I am coming at this from a slightly different direction. Suppose you just had data on the earnings yield of stacks compared to bonds. (Ignore risk for simplicity). If bonds had a higher earnings yield than stocks, would that mean that stocks were overvalued? (I.e. would it mean that the price of stocks was higher than it should be?) Or could inflation make this a biased comparison?
Bob: thanks for that. I’m playing it through in my mind, trying to come up with a simple example for my intuition to work on.
Hi Nick,
“Put it another way. if a corporation has real assets, and uses a mix of debt and equity finance, the value of the shareholders’ assets, net of the debt, should be rising even faster than inflation in nominal terms.”
I would take this further. If you think of a firm’s stock as a call option on the value of its assets, then for a firm with real assets that is not in liquidation, there is always option value greater than zero. Therefore, simply looking at the earnings yield will lead you to understate the value of the stock, regardless of the capital structure of the company.
So in your 100% equity farm example, it’s not true that you would be indifferent. Or rather, you shouldn’t be; you should buy the stock if it is priced the same as the bond.
Sorry, I did not mean “real assets” in my previous post, I meant assets whose prices go up with inflation, like your farm.
“If there’s 2% inflation, a 2011 dollar is worth 98 cents in 2010 dollars”
The financials should adjust the other way (convert 2010 dollars to 2011 dollars) since an investor would want the current year’s statement to be in terms of current money. Also, IFRS already asks the accountants to adjust for inflation in some cases of hyperinflation. Usually when a firm operates in multiple countries. I don’t think U.S. GAAP does, though.
I’ve enjoyed this conversation. While I understand that the point is to understand minutia of corporate accounting, I think it has gotten to a point of missing the big picture.
As I see it, inflation does two things: it determines the cost of borrowing, and it determines revenue growth over the corporate sector as a whole. While inflation may have little influence over the future growth of revenue for a single firm, it will impact the corparate sector as a whole.
As a simple model, consider an economy with two agents, households and corporations. Households can either buy equity or debt of the corporation. The debt cost should be something like inflation plus a term premium. Equity cost would be a little trickier but you could think of revenue increasing at real gdp + inflation or something similar. Or you could adjust to business cycle. Or adjust to historical ROE.
In the end though, I don’t see why you would expect the risk premium on the bonds to be strictly comparable to the risk premium on the equity. The major risk on the bonds is that your estimation of inflation is wrong. On stocks, there are other problems. One can’t compel dividends. There are problems of agency. And so on. I remember reading that the banks in 09 lost the combined earnings of a phenomenal time period, like a century, or forever, or something like that. Earnings are subject to later revision through writeoff. So you can look at the two risk premia but it is apples and oranges, and adjudging it to be misestimation of inflation seems like a daunting problem.
These articles may interest you:
http://www.ft.com/intl/cms/s/0/ed8cb540-c282-11df-956e-00144feab49a.html#axzz1VER34nb4
http://www.enotes.com/econ-encyclopedia/yield-gap
Theoretically, expected return of equity can be expressed as
k = i + risk premium
It can also expressed as (from DDM; see http://en.wikipedia.org/wiki/Cost_of_capital#Expected_return)
k = dividend yield + growth rate
So,
i – dividend yield = growth rate – risk premium
Note that this “growth rate” includes inflation rate.
Hello. This problem is addressed in a famous paper: Modigliani, F. and R.A.Cohn, 1979, “Inflation, Rational Valuation and the Market”, Financial Analysts Journal, March/April 1979, 35, 24-44
You’ll be pleased to know that you are following in Modigliani’s footsteps!
There is a more concise discussion of the issues in the introduction to Ritter, J.R. and R.S. Warr, 2002, “The Decline of Inflation and the Bull Market of 1982-1999”, Journal of Financial and Quantitative Analysis, March 2002, 37 (1), 29-61. They call the two phenomena that you refer to the Capitalization Rate Error and the Debt Capital Gain Error.
Earnings yield is relative to the market price of the shares, not the market price of the physical assets.
Inflation causes companies which will need to replace inventory or depreciable equipment or buildings to overstate earnings because they understate the cost of continuing in business.
Inflation causes companies with debt to understate earnings because their interest expense is overstated by the inflation rate times their outstanding debt.
Trying to use “real dollar” accounting is the road to financial hell (I think Argentina tried it.)
IMHO the charts published by Felix Salmon are the result of two factors: there is a bubble in the bond market driving the nominal yield to historic lows and the earnings being reported by many S&P 500 companies are either not real or not sustainable. For example, companies operating offshore aren’t reserving for taxes payable on repatriation of profits and banks are taking reserves into income. Corporate profits are at historic highs as a share of GDP. In a world awash with capital, that is not sustainable.