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 how much a company earned per share. This yield is used by many 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 (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.
- Earnings yield is 12-month earnings divided by the share price.
- Earnings yield is the inverse of the P/E ratio.
- Earnings yield is one indication of value, as a low ratio may indicate an overvalued stock or a high value may indicate an undervalued stock.
- Growth prospects for a company are critical to consider when using earnings yield, as stocks with high growth potential are typically higher valued and thus may have a low earnings yield even as their stock prices are rising.
Earnings Yield vs. P/E Ratio
Earnings yield as an investment valuation metric is not as widely used as the P/E ratio. 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. That said, the metrics provide the same information, just in a different way.
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 may earn for investors, rather than a valuation metric of how the investment is valued 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. This is because the higher the stock price goes, without a comparable rise in earnings, the earnings yield will drop. If the stock price falls, but earnings stay the same or rise, the earnings yield will increase. Value investors look for the latter scenario.
The inverse relationship between earnings yield and P/E ratio indicates 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. This is what growth investors are looking for. 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.
Examples of Earnings Yield
Earnings yield is one metric investor can use to assess whether they want to buy or sell a stock.
In April of 2019 Facebook (FB) was trading near $175 with 12-month earnings of $7.57. This gives a earnings yield of 4.3%. This was historically quite high, as prior to 2018 the yield had been 2.5% or lower. Between 2016 and the end of 2017 the stock increased by more than 70% while the earnings yield increased from about 1% to 2.5%.
The stock fell more than 40% off its 2018 high while the earnings yield was near its highest historical level, about 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 may have played a role in driving the stock higher, mainly because investors expected earnings to increase going forward. Yet a high earnings yield (relative to prior readings) didn't prevent the stock from seeing a significant decline in 2018.
Earnings yield may also be useful in a stock that is older and has more consistent earnings. Growth is expected to be low for the foreseeable future, so the earnings yield can be used to determine when it is a good time to buy the stock in its cycle. A higher than normal earnings yield indicates the stock may be oversold and could be due for a bounce. This assumes nothing negative has happened with the company.