What is Earnings Yield
The earnings yield refers to the earnings per share for the most recent 12-month period divided by the current market price per share. The earnings yield (which is the inverse of the P/E ratio) shows the percentage of each dollar invested in the stock that was earned by the company. This yield is used by many investment managers to determine optimal asset allocations.
BREAKING DOWN Earnings Yield
Money managers often compare the earnings yield of a broad market index (such as the S&P 500) to prevailing interest rates, such as the current 10-year Treasury yield. If the earnings yield is less than the rate of the 10-year Treasury yield, stocks as a whole may be considered overvalued. If the earnings yield is higher, stocks may be considered undervalued relative to bonds.
Economic theory suggests that investors in equities should demand an extra risk premium of several percentage points above prevailing risk-free rates (such as rates on Treasury bills) in their earnings yield to compensate them for the higher risk of owning stocks over bonds and other asset classes.
Earnings Yield vs. P/E Ratio
Earnings yield as an investment valuation metric is not as widely used as its P/E ratio (price-earnings ratio) inverse in stock valuation. Earnings yield can be useful when concerned about the rate of return on an investment. For equity investors, however, earning periodic investment income may be secondary to growing their investments' values over time. This is why investors may refer to value-based investment metrics such as P/E ratio more often than earnings yield when making stock investments.
Earnings Yield and Return Metric
For investors looking to invest in stocks with stable dividend income, earnings yield can offer a direct look into the level of return such dividend stocks may generate. In this case, earnings yield is more of a return metric about how much an investment can earn back for investors, rather than a valuation metric about how much the investment is valued in the market by investors. However, a valuation metric such as P/E ratio can affect a return metric like earnings yield. An overvalued investment can lower earnings yield and, conversely, an undervalued investment can raise earnings yield.
Earnings Yield and Valuation Metric
The inverse relationship between earnings yield and P/E ratio seem to indicate that the more valuable an investment is, the lower the earnings yield may be, and the less valuable an investment is, the higher the earnings yield may be. In reality, however, investments with strong valuations and high P/E ratios might generate more earnings over time and eventually boost up their earnings yield. On the other hand, investments with weak valuations and low P/E ratios might generate less earnings over time and, in the end, drag down their earnings yield.