Earnings Yield vs Bond Yield: How to Know When Stocks Are Cheap vs Bonds

Earnings Yield vs Bond Yield: How to Know When Stocks Are Cheap vs Bonds

When is it a better time to own stocks than bonds? When is the equity risk premium compelling versus thin? These questions sound macroeconomic and abstract, but they can be answered with a simple comparison: the earnings yield of the stock market against the yield on 10-year Treasury bonds.

This comparison is one of the oldest and most intuitive tools in value investing. It tells you, in percentage terms, how much the stock market is earning relative to its price — and whether that return looks attractive compared to risk-free government bonds.

This article is for educational purposes only and does not constitute financial advice.

What Is Earnings Yield?

Earnings yield is simply the inverse of the price-to-earnings (P/E) ratio:

Earnings Yield = Earnings Per Share ÷ Share Price = 1 ÷ P/E

If a stock has a P/E ratio of 20, its earnings yield is 1/20 = 5%. If a stock has a P/E of 10, its earnings yield is 10%. If a stock has a P/E of 40, its earnings yield is 2.5%.

The earnings yield answers a natural question: for every $100 I invest in this stock today, how many dollars per year does the company earn on my behalf?

This framing makes stocks directly comparable to bonds. A bond with a 4.5% yield returns 4.5 cents per dollar invested each year (in interest). A stock with a 5% earnings yield earns 5 cents per dollar of market cap each year (in earnings, not necessarily dividends).

Earnings Yield vs Dividend Yield

These are related but distinct:

• Earnings yield: Total earnings divided by market cap. Measures all earnings generated, whether distributed or retained.
• Dividend yield: Dividends paid divided by market cap. Measures only the cash returned to shareholders.

A company could have a 7% earnings yield but a 2% dividend yield if management retains 70% of earnings for reinvestment. The earnings yield captures the full economic benefit to owners even when dividends are low.

The Fed Model: Stocks vs Bonds

The "Fed Model" — named because it was associated with Federal Reserve research in the 1990s (though not officially endorsed by the Fed) — compares the S&P 500 earnings yield directly against the 10-year Treasury yield.

Fed Model Logic:

• When earnings yield > 10-year Treasury yield: Stocks are cheap relative to bonds. The equity premium is positive and meaningful. Historically, this condition has preceded periods of above-average stock market returns.
• When earnings yield < 10-year Treasury yield: Stocks appear expensive relative to bonds. The equity premium is compressed or negative. Stocks must grow earnings to justify their prices relative to bonds.

Historical Context

The Fed Model relationship was particularly tight during the 1980s–2000s when inflation and interest rates moved through wide ranges. In periods of very low rates (2010–2021), the comparison broke down somewhat — the 10-year Treasury yielded near zero, making almost any positive earnings yield look attractive by comparison, regardless of whether stocks were truly cheap in absolute terms.

At its core, the comparison works because both stocks and bonds are claims on future cash flows. When risk-free rates rise, all asset prices must compete with higher guaranteed returns — which is why rising rates are generally bearish for P/E multiples, and falling rates are generally bullish.

Historical S&P 500 Earnings Yields

Understanding historical context prevents misreading current levels:

The most compelling equity returns in history have followed periods of high earnings yields — when stocks were genuinely cheap relative to their earning power. The 1980s stock market boom followed a period when the S&P 500 earnings yield exceeded 10%. Investors who owned stocks in 1982 were earning double-digit yields on a diversified index at the same time that bond yields were also high — but stocks had the additional benefit of earnings growth.

Greenblatt's Magic Formula: Earnings Yield as a Core Metric

Joel Greenblatt's Magic Formula (introduced in The Little Book That Beats the Market) uses earnings yield as one of its two primary ranking criteria. Greenblatt defines earnings yield as:

Greenblatt Earnings Yield = EBIT ÷ Enterprise Value (EV)

This is slightly different from the standard E/P ratio because:

• EBIT (instead of net income) removes the effects of tax rates and capital structure, making comparison across different leverage levels and tax jurisdictions more consistent
• Enterprise Value (instead of market cap) accounts for debt and cash, making the comparison capital-structure-neutral

A company with $100M EBIT and $1B enterprise value has a 10% Greenblatt earnings yield. Greenblatt screens for the highest-ranked companies on earnings yield combined with return on capital — buying cheap companies that are also good businesses.

The empirical result: stocks ranking in the top decile on both metrics have historically delivered above-market returns over multi-year holding periods, even though year-to-year results are volatile.

When Earnings Yield > Bond Yield: Historical Implications

Benjamin Graham, the father of value investing, wrote about this relationship in The Intelligent Investor. His "central value" formula for the stock market was essentially: stocks are cheap when the earnings yield is meaningfully higher than prevailing bond yields.

The historical pattern:

• 1974: S&P 500 earnings yield well above bond yields → subsequent 10-year returns were strong
• 1982: Earnings yield above 10%, even as bond yields were also near 15% → stocks began the greatest bull market in modern history
• 2009: Earnings yield spiked to 7–8% while 10-year Treasury dipped below 3% → 10-year forward returns were among the best since the 1980s
• 1999–2000: Earnings yield fell to 2.3% while 10-year Treasury yielded 6–7% → earnings yield was deeply below bond yield; the subsequent decade delivered near-zero returns for the S&P 500

The pattern is not perfect. Earnings yield does not predict short-term market moves. But over 5–10 year horizons, the starting earnings yield relative to bond yields has been one of the most reliable predictors of equity returns available to investors.

Applying Earnings Yield to Individual Stocks

The comparison works at the individual stock level too. The question is not just "is this stock cheap?" but "is this stock cheap relative to what I can earn risk-free?"

Example Framework

Assume the 10-year Treasury yields 4.5%.

• Stock A: P/E of 15 → Earnings yield 6.7% → Premium over bonds: 2.2 percentage points
• Stock B: P/E of 30 → Earnings yield 3.3% → Discount to bonds: -1.2 percentage points (bonds earn more)
• Stock C: P/E of 10 → Earnings yield 10% → Premium over bonds: 5.5 percentage points

Stock C appears most attractive on this metric. Stock B would need to grow earnings substantially to justify paying a premium over risk-free government bonds.

The required equity risk premium (what investors demand above risk-free rates to hold stocks) has historically averaged 3–5 percentage points. A stock offering 4%+ above Treasury yields is pricing in very modest growth expectations — potentially an opportunity. A stock offering less than Treasury yields requires strong growth to justify the equity risk.

Limitations of the Earnings Yield / Bond Yield Comparison

1. Earnings are cyclical. A mining company at peak commodity prices may have a high earnings yield that overstates normalized earning power. Always consider normalized or through-cycle earnings, not just trailing 12 months.

2. Quality of earnings matters. A 10% earnings yield backed by real cash flows is far more valuable than a 10% earnings yield backed by aggressive accruals. Run earnings quality checks alongside any yield-based screen.

3. Growth changes the equation. A high-earnings-yield company with declining earnings is a value trap. A moderate-earnings-yield company with 15% annual earnings growth may be the better investment. The earnings yield comparison is most powerful for stable, mature businesses.

4. The Fed Model has critics. Some academics argue stocks and bonds are not directly comparable because earnings can grow (bonds cannot). Inflation erodes bond returns but nominal corporate earnings may keep pace with inflation.

5. Interest rate distortions. Near-zero rates in 2010–2021 made the comparison less useful — when bonds yield 0.5%, even mediocre stocks look good on relative yield.

Using Earnings Yield on ValueMarkers

ValueMarkers displays earnings yield for every covered stock alongside the current 10-year Treasury yield, so the relative comparison is always visible in context. The platform also shows:

• Trailing and forward earnings yield
• Greenblatt-style EBIT/EV yield for leverage-neutral comparison
• Historical earnings yield trend over 5 years
• Sector median earnings yields for peer comparison

Screen for high-earnings-yield stocks relative to current bond yields using the ValueMarkers stock screener.

Summary

Earnings yield — the inverse of the P/E ratio — is one of the most direct measures of stock value. Comparing it against the 10-year Treasury yield answers the fundamental question every investor faces: are stocks offering a compelling return relative to risk-free alternatives?

Key takeaways:

• Earnings yield = EPS ÷ Price = 1 ÷ P/E
• When earnings yield significantly exceeds bond yields, stocks have historically delivered strong forward returns
• Greenblatt's Magic Formula uses EBIT ÷ EV as a capital-structure-neutral version
• The comparison is most reliable over 5–10 year horizons, not for market timing
• Always pair earnings yield analysis with earnings quality checks and growth assessment

The power of the comparison lies in its simplicity: it translates the complex question of stock valuation into the same percentage terms used for every other investment — making stocks directly comparable to bonds, real estate, or any other asset class.

All content is for educational purposes only. This is not financial advice. Always conduct your own due diligence before making investment decisions.