In Example 12, Reading 16, Book 3, pg 151 of CFAI curriculum, the Solution to Question 1 shows that if the Yardeni fair value estimate is higher than the current S&P 500 earnings yield, equities are overvalued. I thought it was the other way around. Isn’t the Yardeni fair value estimate an estimate of intrinsic value suggesting that if it is higher than the current earnings yield equities are undervalued and will rise? Any input would be appreciated. Thanks.
You are correct in everything you say about intrinsic value and market prices but read a little more carefully…the question asks about earnings yield not prices. Remember earnings yields (e/p) and equity prices move inversely. In this case, Yardeni’s earnings yield is 5.89% (higher earnings yield, lower market price) and the market yield is 5.5% (lower earnings yield, higher market price). Thus the answer is correct because the market earnings yield is lower it implies a higher market price vs. the intrinsic earnings yield and thus “equity prices are overvalued.”
I hope that helps,
Marc A. LeFebvre, CFA
Excellent explained, I had the same doubt …
Thank you, Marc! Much appreciated.