What is Earnings Yield?

Earnings yield is defined as the quotient of earnings per share (EPS) divided by the share price. Mathematically, it is the reciprocal of the well-known price-to-earnings (P/E) ratio. To illustrate this concept, let’s consider two stocks: Stock A with an EPS of $5 and a share price of $100, and Stock B with an EPS of $3 and a share price of $50. The earnings yield for Stock A would be 5% ($5 / $100), while for Stock B it would be 6% ($3 / $50). This simple calculation gives you a quick snapshot of which stock might offer a better return per dollar invested.

How to Calculate Earnings Yield

Calculating earnings yield is straightforward once you understand its components:

• Earnings Per Share (EPS): This is calculated by dividing the net income of the company by the total number of diluted shares outstanding.

• Share Price: This is simply the latest closing market share price.

The formula for earnings yield is:

[ \text{Earnings Yield} = \frac{\text{EPS}}{\text{Share Price}} ]

For example, if Apple has an EPS of $12.50 and its current share price is $150, the earnings yield would be:

[ \text{Earnings Yield} = \frac{12.50}{150} = 0.0833 \text{ or } 8.33\% ]

Similarly, for a market index like the S&P 500, you would use the average EPS of all constituent companies and the index’s current value.

Earnings Yield vs. P/E Ratio

The P/E ratio and earnings yield are closely related but offer different insights. The P/E ratio indicates how long it would take for the company to sustain its earnings to reach the current share price. On the other hand, earnings yield shows the return per dollar invested in terms of earnings.

For instance, if a stock has a P/E ratio of 20, its earnings yield would be 5% (1/20). This means that for every dollar you invest, you can expect a 5% return in terms of earnings. Comparing these metrics can help investors understand whether a stock is overvalued or undervalued relative to its peers or other investment options.

Interpreting Earnings Yield

Interpreting earnings yield involves understanding it as both a rate of return and a valuation metric. It helps investors compare returns across different investments such as stocks, bonds, and other fixed-income options. For example, if the earnings yield of a stock is higher than the yield on a 10-Year Treasury Bond, it might indicate that the stock offers a better return for taking on additional risk.

Earnings yield also helps in evaluating risk premiums. If the earnings yield of a stock is significantly higher than that of a risk-free asset like Treasury bonds, it may suggest that investors are demanding higher returns due to perceived risks associated with the stock.

Comparative Statistics and Examples

Let’s compare real-world examples to see how earnings yield can be used in practice. Suppose the S&P 500 has an average EPS of $150 and its current index value is $4,500; this gives an earnings yield of approximately 3.33%. If the 10-Year Treasury Bond yield is around 2%, this suggests that investors are expecting higher returns from equities compared to fixed-income investments.

Such comparisons can also help in evaluating whether a particular stock is undervalued or overvalued relative to its peers or other investment options.

Practical Applications for Investors

Earnings yield is a powerful tool for making informed investment decisions. It highlights the importance of earnings in driving long-term stock performance and dividends. Investors can use this metric to compare different stocks or indices and decide where their money might be best allocated.

The Fed model, which compares the earnings yield of the S&P 500 to the yield on long-term Treasury bonds, is another practical application. Adjusted versions like Joel Greenblatt’s adjusted earnings yield formula further refine this metric by considering additional factors such as debt levels and cash flow.