The Earnings Yield explained.

The Earnings Yield is a financial metric used to measure the indicative rate of return on a stock. It is calculated by dividing the company’s earnings per share by the stock price, which forms the Earnings Yield (E/P). This ratio is not commonly used for valuation, but it is an effective way to look at what sort of returns one can expect.

The Earnings Yield tells an investor how much the company expects to earn for every dollar of stock owned, by showing the percentage of a company’s earnings per share. For instance, if a company has an earnings yield of 10%, it means that the company expects to earn $10 for every $100 worth of shares owned.

Although the Earnings Yield is used more often as a measure of return over valuation, some investors use it as a benchmark to determine if a stock is undervalued or overvalued. If there is a concern about the rate of return, one can compare the current E/P with other forms of opportunity cost like bonds or other stocks. However, the Price-to-Earnings (P/E) ratio is more commonly used for valuation.

Investors seeking income can use the Earnings Yield as it considers dividend income and provides a more robust look at the overall return an investor may get. Investments that are considered overvalued will often have a lower Earnings Yield, whereas undervalued investments will often raise the yield. This fluctuation in earnings yields is directly related to the correlation between price and earnings.

A low Earnings Yield is often found in investments that have a growing stock price much faster than the earnings are growing. Conversely, if the earnings remain stable and the stock price drops, the earnings yield then rises.

To me, Earnings yield is often a shorter-term or income focused metric. As a growth-orientated investor, finding good quality opportunities with stronger valuations means the E/P is often always low. Over time, as the company grows its earnings, the yield changes accordingly and will rise. Value investors will often look for higher earnings yields which can indicate undervalued opportunities with a lower P/E. They buy and wait for the company to revert to the mean and make money on the closing of this gap between price and intrinsic value.

The earnings yield tells an investor how much is earned per share held, the P/E ratio tells the investor how long it would take for the company to sustain its earnings to reach the current share price.

What is the Earnings Yield formula?

• Earnings Yield = Earnings Per Share ÷ Price Per Share
• Simply flip the P/E Ratio around.
• Multiply the decimal x100 to get the % yield.

Using a very simple method if you know the Price-to-Earnings ratio simply invert it. For example, if the P/E is 20 simply divide 1 into 20. 1÷20×100 = 5% Earnings Yield. The higher the P/E the lower the yield will be.

How to use the E/P Ratio?

Using the earnings yield is a great way to compare investment opportunities beyond public equities. For instance, suppose we see a business with a P/E of x30. In that case, we can calculate that 1 ÷ 30 x 100 would yield us 3.33%. If the business’s fundamentals don’t show capital growth prospects, and we think it’s “overvalued,” we can compare it to other income-generating opportunities such as bonds or fixed deposits.

If a fixed deposit returns 4.85% annually with minimal to no downside at all, why would we assume the risk of investing in the stock at such a low yield and a lack of growth opportunity?

However, if the company with a P/E of x30 had growth prospects that could compound our capital and then, as earnings increase, provide a higher yield later on top of compounded capital, that would be a more viable opportunity. If a value investor was looking at a higher yield on a company that had a low trailing P/E of let’s say x7, then the Earnings Yield would be 14.28%.

This E/P is significantly greater than a bond or fixed deposit return, so we can determine whether the additional return is worth taking the risk. Suppose the undervalued company does not continue to disappoint. In that case, the value investor will get a higher rate of return while the company makes its turnaround and closes in on the desired price point.

Let’s use two companies competing in the same industry to determine which one would make a better investment based on the Earnings Yield.

Earnings Yield	Company A	Company B
Closing Share Price	$7.50	$12.75
Net Income	$95 million	$147 million
Shares Outstanding	100 million	227 million
Earnings Per Share (EPS)	$0.95	$0.64
Price-to-Earnings	7.89x	19.92x
Earnings Yield %	12.67%	5%

In this simple example, we can see that Company A with the lower P/E ratio of 7.89 has a higher Earnings Yield of 12.67% compared to Company B with only 5%. This suggests that Company A is the better investment when looking at the E/P by itself as it expects to earn $12.67 for every $100 worth of shares, or for every dollar invested it would present 12.67 cents of earnings per share.

We need to look at the fundamentals behind Company B before we discard it as the “poorer” option simply due to a lower earnings yield or even a higher P/E ratio. As companies mature and establish their competitive and market position over time, the yield tends to increase as the P/E begins to stabilise. If the underlying business of Company B does not measure up to that of Company A then we can go with the investment that provides a higher yield.

The historical growth trajectory and the future growth prospects each represent important factors that can impact the Earnings Yield. When analysing an investment we need to look at how the yield has evolved to determine the value. If for example you are focused on the rate of return then consistency is preferred over very lumpy returns.

Once we have decided that Company A has the better return we can use this as a benchmark to measure against other opportunities in different assets such as the below chart.

Once we have compared the yield to other opportunity costs we can see that a Fixed Deposit of 6.70% is the next comparable opportunity. If we minus the E/P of Company A from the fixed deposit we get a difference of 5.97%. This is our assumed “risk premium” (not a direct method of determining Risk Premium) above what a safe and consistent return would be. We can then as an investor decide whether this additional return is worth taking the extra risk of investing in Company A.

The earnings ratio can be extremely volatile due to fluctuations in the earnings per share (EPS). It is also best used as an indicative return as the actual returns can be significantly different based on so many contributing factors. Some investors assume with an Earnings Yield of say 5% that is what growth/income they are going to receive, however, that is not the case. It is a guide of anticipated return and not actual return. If you want ACTUAL solid returns then Bonds and Fixed income are the better play, hence why we measure against other forms of asset classes and risk profiles.

In Summary…

Using the Earnings Yield is better equipped for mature companies with consistent earnings or income-focused investors. Investment style will play a big part in who uses the earnings yield. If finding hyper-growth opportunities is what you are focused on then the yield will be pointless and often non-existent. I believe it is best used alongside the Price-to-earnings ratio. The reason why is if a company can be valued using the P/E then the rate of return can also be measured. If an early-stage or hyper-growth company can not be valued with the P/E as a lot of them require the denominator of “earnings” then I why use the earnings yield in that case also.

If I find an undervalued opportunity and I am confident of the underlying business’s stability to improve performance I will consider the E/P against other opportunity costs and competitors in the same industry.

* I use the Earnings Yield multiple in my valuation work and specifically in the Discounted Cash Flow modelling. Whilst not a conventional way to use it, I have found other successful investors who use it when determining the Cost of Capital. When valuing a company in a certain industry I sometimes take the average Earnings Yield of all the competitors including the benchmark to create an indicative Cost of Equity (I discuss this in another article). I use this method because technically the E/P is what we would have to be “offered” to invest in that company.