The Adjusted Earnings Yield

The earnings yield, determined by the ratio of reported earnings to price, is frequently used to predict real return. Complications characterize the predictions, however, because reported earnings are not real. This research identifies an adjusted earnings yield that ensures that real return can be determined as a ratio of current-period prices. From freely accessible and publicly disseminated data, an adjusted-earnings-yield series is created for the U.S. equity market. Statistical tests indicate that this measure is a much better predictor of future real returns than are other popular valuation measures. The earnings yield, determined as the ratio of reported earnings to price, is frequently used by analysts to predict real equity returns. This approach has advantages, particularly when share buybacks and other actions affecting shareholder returns are a significant use of earnings. Complications do exist, however, because reported earnings are not real and are invariably affected by past and expected changes in the price level. The research reported here identified anadjusted earnings yield as an intuitively appealing approach to estimating real expected return. An accounting adjustment and a debt adjustment are both necessary to convert reported earnings into a measure of real profitability. The accounting adjustment converts reported earnings into a current-cost (or replacement-cost) accounting system. The debt adjustment corrects for the impact that inflation has on the real value of creditor claims. Adjusted earnings are, then, the sum of reported earnings, the accounting adjustment, and the debt adjustment. The adjusted earnings yield, determined as the ratio of adjusted earnings to equity value, ensures that real return is determined as a ratio of current-period prices. Using freely accessible and publicly disseminated data, I created an adjusted-earnings-yield series for the U.S. equity market. I used a predictive regression model to test the hypothesis that this valuation measure is superior to other commonly used valuation measures as a predictor of future real equity returns. Statistical tests confirm that it is, indeed, a better measure, particularly when the goal is to forecast near-term real returns. The article also provides evidence that the accounting and debt adjustments made to reported earnings are each important considerations if the goal is to accurately forecast real equity returns. Results of the predictive regression models indicate that the coefficient estimate for the accounting adjustment variable is statistically significant for all the time horizons considered and the coefficient estimate for the debt adjustment variable is statistically significant at longer time horizons. Although the regression results suggest that the accounting adjustment is the more important adjustment, the debt adjustment was actually found to be more highly positively correlated with future real returns, and the difference increases with the length of the investment horizon. An explanation commonly offered for the low real returns of the 1970s and the high real returns of the 1980s and 1990s is that investors were simply behaving irrationally. The results of this study suggest, however, that a plausible, albeit only partial, explanation of why real returns varied as they did is that market participants rationally recognized that traditional measures of market valuation, such as P/E or the earnings yield, were misstating the true worth of equities. The variation in real returns appears to be somewhat more rational once the accounting and debt adjustments are considered. The adjusted earnings yield suffices as a stand-alone measure of real expected return, and investors should be most concerned with its level. As of the third quarter of 2006, the adjusted-earnings-yield series developed for the U.S. equity market was predicting a real return of 6.1 percent. But forecasts change quarterly with the arrival of new data, and the current economy raises some concerns. Recent trends in fixed capital investment and borrowing suggest a slowing of the U.S. economy, which may adversely affect share prices.