Earnings Yield and Value Investing

The Earnings Yield is the ratio of a company’s last twelve months of earnings per share to its stock price. The result is an estimate of how much in earnings stockholders can expect to receive for each dollar paid for the stock. The earnings yield is the inverse of the Price/Earnings (P/E) ratio and is quoted as a percentage, which allows easy comparison to current bond rates.

Earnings Yield v. Bond Yield

Generally speaking, a yield defines a return on a capital investment of various forms. A yield is typically expressed as a percentage and tracked as an annual figure. As an earnings yield example, if earnings per share for the past four quarters is $2 and the stock price is $20, the earnings yield is 10%. Essentially, it is the amount of earnings you buy for every dollar worth of stock.

Determining Fair Value

Generally, the earnings yields of stocks are higher than the yield of risk-free treasury bonds. This premium reflects the additional risk associated with stock investing. The historical average P/E ratio for U.S. stocks of about 14 translates to an earnings yield of just over 7%.

Investors often compare the earnings yield of a market index, such as the S&P 500, to current interest rates in an effort to determine whether stocks as a whole might currently be over or undervalued. If, for example, the earnings yield of the index is less than the rate of the 10-year Treasury yield, stocks as a whole may be currently overvalued. If the earnings yield is higher, stocks could be undervalued in comparison to bonds.

Earnings Yield and Value Investing

To value investors, the earnings yield can provide a tool in finding undervalued stocks since a high earnings yield can indicate a “bargain” stock. On the other hand, a low earnings yield can indicates an overvalued one.

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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.

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