Earnings Yield
What Is Earnings Yield?
The earnings yield refers to the earnings per share for the latest year period divided by the current market price per share. The earnings yield (the inverse of the P/E ratio) shows the percentage of a company's earnings per share. Earnings yield is used by numerous investment managers to determine optimal asset allocations and is used by investors to determine which assets seem underpriced or overpriced.
How Earnings Yield Works
Money managers often compare the earnings yield of a broad market index to prevailing interest rates, for example, the current 10-year Treasury yield. In the event that the earnings yield is less than the rate of the 10-year Treasury yield, stocks might be considered overvalued. Assuming the earnings yield is higher, stocks might be considered undervalued relative to bonds.
Economic theory suggests that investors in equities ought to demand an extra risk premium of several percentage points above prevailing risk-free rates in their earnings yield to compensate them for the higher risk of possessing stocks over bonds.
Earnings Yield versus P/E Ratio
Earnings yield as an investment valuation metric isn't quite so widely used as the P/E ratio. Earnings yield can be helpful when there is concern about the rate of return on an investment. However, for equity investors, earning periodic investment income might be secondary to developing their investment values over time. For this reason investors might refer to value-based investment metrics like the P/E ratio more often than earnings yield when making stock investments. All things considered, the metrics provide the same data, just another way.
Earnings Yield and Return Metric
For investors hoping to invest in stocks with stable dividend income, earnings yield can offer a direct investigate the level of return dividend stocks might generate. In this case, earnings yield is more of a return metric, revealing how much an investment might earn for investors rather than a valuation metric showing how investors value the investment. However, a valuation metric like the P/E ratio can affect a return metric like earnings yield.
A overvalued investment can lower earnings yield, while a undervalued investment can raise earnings yield. This is because the higher the stock price goes without a comparable rise in earnings, the lower the earnings yield will drop. Assuming that the stock price falls yet earnings stay the same or rise, the earnings yield will increase. Value investors seek the latter scenario.
The inverse relationship between earnings yield and the P/E ratio indicates that the more valuable an investment, the lower the earnings yield, and the less valuable an investment, the higher the earnings yield. However, investments with strong valuations and high P/E ratios could generate lower earnings over time and eventually help their earnings yield, and this is what growth investors search for. Then again, investments with weak valuations and low P/E ratios might generate lower earnings over time and, eventually, drag down their earnings yield.
Example of Earnings Yield
Earnings yield can help investors assess whether or not they need to buy or sell a stock.
In April of 2019, Meta (META), formerly Facebook, was trading near $175 with year earnings of $7.57, which produced an earnings yield of 4.3%. This was historically high as the yield had been 2.5% or lower before 2018. Between 2016 and 2017, the stock increased by more than 70%, while the earnings yield increased from approximately 1% to 2.5%.
The stock fell more than 40% off its 2018 high, while the earnings yield was near its highest historical level, around 3%. After the decline, the earnings yield continued to creep higher as the price fell, reaching over 5% in early 2019 when the stock started to bounce back higher.
The increased earnings yield might have played a role in driving the stock higher, for the most part because investors expected earnings to improve proceeding. A high earnings yield (relative to prior readings) didn't prevent the stock from seeing a huge decline in 2018.
Earnings yield may likewise be helpful in a stock that is older and has more consistent earnings. In the event that growth is expected to be low for the foreseeable future, the earnings yield can be used to determine when it is a great time to buy the stock in its cycle. A higher than typical earnings yield can indicate the stock might be oversold and could be due for a bounce higher, expecting no negative news has occurred inside the company.
Highlights
- Earnings yield is one indication of value; a low ratio might indicate an overvalued stock, or a high value might indicate an undervalued stock.
- The growth prospects for a company are a critical consideration when utilizing earnings yield. Stocks with high growth potential are typically valued higher and may have a low earnings yield even as their stock price rises.
- Earnings yield is the year earnings divided by the share price.
- Earnings yield is the inverse of the P/E ratio.
