According to the Yardini model, what does E1/P0 equal?

In the Yardini model, E1/P0 represents the expected earnings yield of the stock market, which is a useful measure for gauging the expected return on equities. The formula provided in choice B—that E1/P0 equals bond yield minus the product of the dividend payout ratio and long-term earnings growth rate—captures the essence of how expected equity returns are related to bond yields and corporate earnings.

This relationship reflects the notion that investors require a certain risk premium to invest in equities compared to bonds. The bond yield serves as a baseline return for taking on the relative risk of stocks. The dividend payout ratio, when multiplied by the long-term earnings growth, adjusts the expected returns to account for the portion of earnings not paid out as dividends, which reflects the retention of earnings for growth purposes. As such, the difference between the bond yield and this product gives a clearer picture of what investors might expect from equities after considering dividends and the growth potential retained within those companies.

Therefore, this relationship illustrates how the yield from equities is influenced by both fixed income securities and the distinctive characteristics of earnings dynamics in the equity markets.