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The price/earnings ratio is a stock’s price divided by its earnings per share. It works well for valuation, but not for evaluating potential returns among different investments. That’s where earnings yield comes in.

Earnings yield is EPS divided by the stock price. It’s the reciprocal of the P/E ratio. EPS is net income divided by outstanding shares, and it measures a company’s profitability.

If Stock A is trading at $10 and its EPS for the past year was 50 cents, it has a P/E of 20, and an earnings yield of 5%.

If Stock B is trading at $20 and its EPS is $2, its P/E ratio is 10, and its earnings yield is 10%.

B is the better value. Its P/E ratio is lower, and its earnings yield of 10% means that for every dollar invested, its stock generates 10 cents of earnings per share.

P/E ratios work best when they’re used to compare companies in the same sector, or the stock of one company over different periods of time. It’s also useful to compare the P/E to earnings growth or the PEG ratio. If a company has a P/E of 10 and earnings of 10%, its PEG ratio is 1. If another company has a P/E of 10 and earnings growth is 20%, its PEG is 0.5. It’s undervalued compared to the first.

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