Stock Fundamentals

Using the Fed Model to analyse stocks

Hari Viswanath | Updated on February 20, 2021

If risk-free investment is the bird in hand, stock valued on expectations is the one in bush

John Maynard Keynes once said: “The superiority of stocks isn’t inevitable. They own the advantage only when certain conditions prevail.” Stocks which are overvalued do not own any advantage but irrational investor expectations.

Hence, trimming positions – in some cases completely exiting excessively-valued stocks – may be a prudent strategy. Markets are replete with instances of stocks never ever reaching their all-time highs or taking many years to claw back to all- time highs after reaching excessive valuation zones.

For example, even when market indices are at all-time highs, a frontline stock, Maruti, is more than 25 per cent below its all-time high reached more than three years ago in 2017.

Stocks which have performed well in recent years, such as Reliance Industries and Bharti Airtel, took 10 years to cross their peak levels reached in 2007.

Such things happen because investors overvalue stocks in a state of euphoria.

While valuation is not a perfect science and involves judgement, the case for stocks, at the same time, cannot be built and sustained entirely on judgements like ‘there is no alternative’or ‘this time it’s different’.

In this week’s series, we will discuss how the metric known as the ‘Fed Model’ can be used to identify over-valued stocks.

 

Earnings yield vs risk-free yield

Earnings yield is the inverse of PE (1/PE). How the earnings yield compares vs risk- free yield is a good staring point to assess the valuation of stocks. The Fed Model is based on the name given to it in the late 1990s by the then Deutsche Bank analyst Edward Yardeni.

It measures the relation between the 10-year risk-free yield and the one-year forward earnings yield on the index or specific stocks.

The lower the earnings yield vs the 10-year risk-free yield, the more unattractive is the stock and vice versa. While the Fed Model was conceived to assess relative market valuation in aggregate and not at an individual stock level, it can be used as one of the factors for analysing stocks to get a perspective . There is this age-old proverb, ‘A bird in hand is worth two in the bush. Your risk-free investment option is your bird in the hand.

If the stocks that are valued based on investor expectations of future business performance is the bird in the bush, the trade-off between the two can be analysed to assess whether the index or stock is expensive or cheap relatively. In India, the 10-year risk-free yield is currently around 6 per cent.

Comparing the indes yields or specific stock yields can help identify possibilities of over-valuation.

For example, based on current consensus expectations Titan earnings yield is around 2 per cent vs 10-year risk-free yield at 6 per cent (see the accompanying table).

What investors are believing now is that one risk-free bird is worth 0.26 Titan bird in the bush (forget 2 birds!).

It is a similar story at the index level. In India, investors believe one risk-free bond on hand is worth 0.67 Sensex in the bush, while those investing in the US believe 1 risk-free bond in the US is worth 3.58 Dow Jones Industrial Average in the bush. While other factors, earnings growth, for instance, for the next few years need to be assessed to determine a more conclusive case of over-valuation, the historical trend does not justify these valuations – given that corporate earnings growth in India has been weak in the last decade.

Similarly, investors need to assess extreme over-valuations based on the Fed model in the stocks of Nestle or Asian Paints.

These premium Indian birds in the bush must lay a lot of golden eggs in the future to justify their premium, as per the Fed model. Aesop might just have turned in his grave!

Follow us on Telegram, Facebook, Twitter, Instagram, YouTube and Linkedin. You can also download our Android App or IOS App.

Published on February 20, 2021
  1. Comments will be moderated by The Hindu Business Line editorial team.
  2. Comments that are abusive, personal, incendiary or irrelevant cannot be published.
  3. Please write complete sentences. Do not type comments in all capital letters, or in all lower case letters, or using abbreviated text. (example: u cannot substitute for you, d is not 'the', n is not 'and').
  4. We may remove hyperlinks within comments.
  5. Please use a genuine email ID and provide your name, to avoid rejection.