Yield gap is a term that is commonly used in the financial world and agriculture as well. For this article, we will primarily be focusing on its financial meaning and relevance. Yield gap (also yield ratio) allows an investor and analyst to compare the performance of shares and bonds. It basically is the difference between the yield on long-term government bonds and the yield on shares (dividend yield) at any given time.
Formula for calculating yield gap is = Yield on Equity/Yield on Bonds
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Dividend Yield and Bond Yield
A dividend yield indicates the amount of dividend that a company pays each year relative to the market value of the shares. Dividend yield, one can calculate by dividing Dividend per Share (DPS) by the market value of the share. One can calculate the DPS by dividing the total dividend by total outstanding shares.
On the other hand, the yield on a bond is the return that an investor gets by investing in bonds. The return on a bond is in the form of the interest that an investor gets from the issuer of the bond.
The yield on bonds can be on three types. Nominal Yield, which one calculates by dividing the interest on bonds by the face value of the bond. Current Yield, one calculates it by dividing earnings from the bond by the current market value of the bond. Required yield is the minimum yield that an investor expects in relation to the risk of investing in that particular bond.
Yield Gap – What it Indicate?
One should normally use the yield gap when evaluating bonds and shares in the same market. The measure is helpful in stock valuation, and also suggests if the equity market is over or undervalued in relation to bonds.
In theory, the bigger the gap (positive), the higher is an opportunity to invest in the stock market, especially during inflationary times. On the other hand, when the consumer prices are more stable, a positive gap is less indicative of the opportunity. During times of stable inflation, investors are okay with a lower bond yield.
Simply say, if the gap is small, or the equity yield is small than the bond yield, it implies that equity is overpriced. On the other hand, if the gap is large, or the equity yield is bigger than the bond yield, it means that equity is cheap.
A yield gap does not remain the same over time and may change due to several reasons, including. If companies go for share-buy backs more than paying dividends, then the yield of shares would come down.
Reverse Yield Gap
It is the amount by which bonds yield exceeds the yield o equity. In other words, it is the amount by which interest on bonds and loans exceeds the cost of equity. Reverse yield ratio mainly comes in use when an average yield on bonds is higher than the dividend yield on stocks.
Yield gap – Agriculture
Remember at the beginning of the article we said that the term yield gap is also commonly used in agriculture. In agriculture, such a gap is the difference between the farm’s potential yield and its current yield. Potential yield means the output if the farm runs well and makes use of the available technology. The measure also helps to compare the country-wise difference between the crop yields.