April 13, 2001

The recent market decline has forced many individuals to reconsider their valuation models. A commonly used approach is to compare the earnings yield (i.e., the inverse of the P/E ratio) to bond yields. Behind this analysis is the presumption that when the earnings yield is higher than bond yields, the market is undervalued, and vice versa. Presumably, a fairly valued market occurs when the earnings yield equals bond yields. We find fault in this analysis.

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