Earnings Yield is the earnings per share of the company for the last twelve months divided by the current market price per share. Usually, it gives the percentage of how much a company has earned per share or the per-share earnings from each dollar invested in the stock.
It is an important financial ratio and is the inverse of PE ratio (price-to-earnings ratio). However, it fails to give the same level of insight into the stock’s valuation as the PE. Thus, we can say, the earning yield is only a good measure to assess the rate of return on investment. However, it is more helpful when comparing potential returns among different securities. When comparing companies, we prefer companies with a higher yield assuming the companies are identical.
Uses of Earnings Yield
- Investment managers find this ratio useful to define the optimal asset allocation in the portfolio of the client. On the other hand, investors use the metric to find out the asset that is underpriced or overpriced.
- Usually, investors and portfolio managers compare the yield of the market index, such as the S&P 500, with the prevailing interest rates, like the 10-year Treasury yield. If the 10-year Treasury yield is more than the index yield, then the stocks as a whole could be overvalued. If the Treasury yield is less, then the stocks are undervalued
- Managers also use the earnings yield to find out the dividend payout ratio, or the proportion of the earnings that the company pays as dividends to its shareholders. One can calculate the dividend payout with the help of earnings yield and dividend yield. The formula for the same is:
Dividend Payout Ratio = Dividend Yield/Earnings Yield
The formula of Earnings Yield is Earnings per share/Stock price per share
In the event of a difference in the capital structure and tax rates between the companies, the adjusted formula for calculating the earnings yield is as follows:
- By calculating earning yield, companies measure returns which in turn help investors to assess if the returns are proportionate with the amount of risk taken. Investors, for instance, might feel that the amount of risk they are taking for a 7.5% yield is inadequate for a particular stock. They might go for the stocks that offer lower-risk and offer a 7.5% yield or more. However, if the average industry yield is 5%, then the same 7.5% might become a preferable investment.
Is P/E Ratio Better?
Earnings yield provides the same information as a P/E ratio but in a different way. Despite this, the latter is more commonly in use. The earning yield primarily focuses on the rate of return on investment. For investors, however, knowing whether or not their investment value will grow over time is more important. Due to this, investors prefer PE, which is a value-based investment metrics, when analyzing stocks.
Earnings Yield as Value Investing Strategy
Though the earning yield can tell if a stock is under or overvalued, it fails to give a clear picture of the quality of earnings. Further, it does not give a clear understanding of the underlying economics of the business. However, when we use it along with other ratios, it can give useful information.
Many portfolio managers, who select stocks on the basis of valuation, interpret the stocks as “equity bonds.” Stocks do not give you the fixed return like the bonds, rather gives a variable return on the basis of the company’s underlying profit. This way it becomes easier to value a business. And, one of the most common methods of valuing the business is to calculate the earnings yield.
As per famous investor Benjamin Graham, investors should not look to invest in a stock with a higher P/E ratio. Instead, they should look for the sum of the earnings yield and growth rate. Simply put, Graham suggests that investors would be safe if they have a well-diversified portfolio and never pay more than the following formula:
P/E Ratio < Earnings Yield + Growth Rate
This approach closely resembles Peter Lynch’s PEG ratio for value investing. Lynch was one of the most successful mutual fund managers but was very conservative in selecting the stocks. Lynch gave more preference to the stocks with earnings growth less than the PE ratio. Although the majority of stocks would be rejected for value investing through this method, the downside would be minimal and the investor would not be exposed to high risk.
- Earnings yield does not always show the true picture of cash available to the investor. This is because; the companies usually reinvest earnings rather than paying dividends to the shareholders. While the dividend yield is dependent on the management decision of capital allocation, earnings yield does not have any such dependability.
- If you are using earning yield as a metric, then it is important to consider the growth prospects of the company as well. Usually, stocks with high growth potential command a higher valuation and may have a low earnings yield even when the stock price is on the rise.
- The earning yield suffers from the same shortcomings as PE. A company may have a high earning yield because of a poor outlook as well. Also, a company can manipulate the earnings in the short-term.
- It does not tell much about the quality of earnings.
Owing to such shortcomings, we can say that it is just one of the measures for evaluating the investments, and not an alternative for an in-depth and comprehensive analysis. So, investors must be careful when using earnings yield, and also use the ratio in combination with other metrics to get more meaningful information.1,2