What it means
Earnings yield is simply a company's annual earnings divided by its share price, which is the price-to-earnings ratio (how many dollars investors pay for each dollar of profit) turned upside down. A market priced at 20 times earnings has an earnings yield of 5%.
The Fed Model sets that figure beside the yield on a 10-year government bond and asks which asset pays more. The name comes from a 1997 Federal Reserve report that showed a link between the two measures, and a market strategist later gave it the label.
The Federal Reserve itself has never used it as an official valuation tool. Treat the name as a nickname rather than an endorsement.
The logic is about competing choices. If a safe government bond pays 5% and the stock market's earnings yield is only 3%, investors are accepting less for taking more risk, which suggests shares are expensive.
If the earnings yield is 7% against the same 5% bond, shares look attractively priced. Finance teams use the model as a quick sense check, for example when judging how rich equity valuations look when setting a discount rate or reviewing an investment portfolio.
It also helps in a conversation about why valuations swing when interest rates move. The model has real weaknesses.
It compares a real asset, whose earnings can grow with inflation, with a nominal bond that pays fixed amounts, and it ignores the extra risk of shares. Critics point out that it has signalled cheapness for long stretches that were followed by poor returns, so it works best as one input rather than a trading signal.
In practice
Real-world examples.
Example
A portfolio manager at a pension fund sees that the equity market's earnings yield is 4.5% and the government bond yield is 6.0%. The negative gap of -1.5% leads her to trim shares and add bonds. She records the model as one of three inputs, not the deciding one.
Example
A corporate treasurer deciding whether to issue new shares or borrow compares the earnings yield on her own stock, 6%, with her bond borrowing cost of 5%. The model suggests equity is cheap relative to debt for investors, which helps her argue for issuing bonds first.
Example
A financial adviser explains to a client why share prices fell when rates rose. As the bond yield climbed from 3% to 5%, the earnings yield of 4% no longer offered a premium, and prices had to adjust.
Formula
Calculation
Earnings yield = earnings per share / share price
Yield gap = earnings yield - 10-year government bond yield
Suppose a stock index trades at 4,000 and the index companies earn $200 per index unit in total. Earnings yield = 200 / 4,000 = 5.0%. If the 10-year government bond yields 4.0%, the yield gap = 5.0% - 4.0% = +1.0%, so shares look reasonably priced under the model. The model's implied fair price to earnings ratio is 1 / 0.04 = 25, which gives a fair index level of 25 x 200 = 5,000, or 25% above the current 4,000.Case study
Seen in the real world.
Ridgeway Capital Partners is an illustrative, fictional investment firm whose investment committee uses the Fed Model as a dashboard indicator. One quarter, the market earnings yield is 4.2% and the 10-year bond yield is 3.0%, a gap of +1.2%, and the dashboard shows green.
An analyst questions the signal. Earnings are at a cyclical high, so she recalculates using average earnings over the past ten years, which gives an earnings yield of only 2.9%, a gap of -0.1%. The signal turns amber.
The committee decides not to increase equity exposure but also not to sell. The illustrative lesson is that the Fed Model is sensitive to which earnings number goes in, and a quick check with smoothed earnings can change the message.
Watch out
Common mistakes.
- Believing the Federal Reserve publishes or relies on the Fed Model, when the name only reflects a 1997 report that noted the link.
- Using peak or one-off earnings, which makes shares look cheaper than they are.
- Treating a positive yield gap as a guaranteed buy signal, when it has been positive for long periods that were followed by weak returns.
Questions
People also ask.
What is a good yield gap?
There is no fixed level; analysts compare the current gap with its own long-run history and treat large positive or negative readings as a prompt for further research.
Why does the model compare earnings with bond yields?
Because both are measures of what an investor receives per dollar invested, so the comparison shows which asset pays more for the price.
Does the Fed Model work for individual stocks?
It is designed for a broad market, but the same idea can be applied to one company by comparing its earnings yield with a bond yield and adding a risk allowance.
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