Earnings yield is a fundamental financial metric that investors use to evaluate the profitability of a company relative to its stock price. While the price-to-earnings (P/E) ratio gets more attention, earnings yield flips the equation, providing a clearer perspective on investment returns. In this article, I break down earnings yield, explain its significance, compare it with other metrics, and demonstrate how to use it in real-world investing.
Table of Contents
What Is Earnings Yield?
Earnings yield measures a company’s earnings per share (EPS) relative to its stock price. It is the inverse of the P/E ratio and is expressed as a percentage. The formula is:
\text{Earnings Yield} = \frac{\text{EPS}}{\text{Stock Price}} \times 100For example, if a company has an EPS of $5 and its stock trades at $100, the earnings yield is:
\frac{5}{100} \times 100 = 5\%This means for every dollar invested in the stock, the company earns 5 cents in profit.
Why Earnings Yield Matters
Earnings yield helps investors compare stocks with bonds, real estate, or other asset classes. Since bond yields are quoted in percentages, earnings yield makes stock returns directly comparable. If a stock has a 6% earnings yield and a 10-year Treasury bond yields 4%, the stock may appear more attractive—assuming equivalent risk.
Earnings Yield vs. P/E Ratio
The P/E ratio is more commonly cited, but earnings yield offers a different lens. The relationship between the two is straightforward:
\text{Earnings Yield} = \frac{1}{\text{P/E Ratio}} \times 100For instance, a P/E of 20 translates to an earnings yield of 5%. While P/E tells you how much investors pay for each dollar of earnings, earnings yield tells you how much profit you get for each dollar invested.
Which One Should You Use?
Both metrics have merit. P/E is useful for growth comparisons, while earnings yield is better for assessing returns. If you want to see how a stock stacks up against bonds, earnings yield is the way to go.
Comparing Earnings Yield Across Industries
Different industries have varying average earnings yields. High-growth tech firms often have lower yields (higher P/Es), while mature utilities may have higher yields (lower P/Es). Below is a comparison table:
| Industry | Avg. Earnings Yield | Avg. P/E Ratio |
|---|---|---|
| Technology | 3% | 33 |
| Utilities | 6% | 16 |
| Consumer Staples | 5% | 20 |
| Financials | 8% | 12 |
This table shows that financial stocks tend to offer higher earnings yields, reflecting their stable cash flows and lower growth expectations.
Earnings Yield and the Fed Model
The Fed Model, a stock valuation tool, compares the earnings yield of the S&P 500 to the 10-year Treasury yield. If the earnings yield is higher, stocks may be undervalued relative to bonds.
For example, if the S&P 500’s earnings yield is 5% and the 10-year Treasury yields 3%, stocks may be a better deal. However, this model has critics—it ignores risk premiums and growth potential.
Calculating Earnings Yield: A Step-by-Step Example
Let’s take Company XYZ:
- EPS (Trailing Twelve Months): $4.50
- Current Stock Price: $90
Using the formula:
\text{Earnings Yield} = \frac{4.50}{90} \times 100 = 5\%Now, suppose the 10-year Treasury yields 2.5%. Since XYZ’s earnings yield (5%) is higher, it might be a better investment—assuming similar risk tolerance.
Limitations of Earnings Yield
While useful, earnings yield has drawbacks:
- Ignores Growth: A high yield may indicate low growth prospects.
- Accounting Variations: EPS can be manipulated via accounting methods.
- Debt Not Considered: Unlike enterprise value-based metrics, earnings yield doesn’t account for debt.
Earnings Yield vs. Dividend Yield
Earnings yield reflects total earnings, while dividend yield shows only what’s paid to shareholders. A company with a high earnings yield but low dividend payout may reinvest profits for growth.
Example:
| Metric | Company A | Company B |
|---|---|---|
| Earnings Yield | 8% | 4% |
| Dividend Yield | 2% | 3% |
Company A retains more earnings for reinvestment, while Company B pays more dividends. Your preference depends on whether you seek growth or income.
Using Earnings Yield in Portfolio Allocation
Investors can use earnings yield to balance stocks and bonds. If stock yields exceed bond yields by a significant margin, shifting toward equities may make sense. However, risk tolerance must be considered.
Historical Context
In the early 1980s, earnings yields were high (10%+) due to high interest rates. Today, with lower rates, earnings yields around 4-6% are more common. This shift reflects changing economic conditions.
Final Thoughts
Earnings yield is a powerful but underappreciated metric. By converting P/E into a percentage, it bridges the gap between stock and bond analysis. While not perfect, it provides a quick way to assess relative value.
