Earnings Yield: How It Works, Examples, and Benefits
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Summary:
Earnings yield is a crucial financial metric that reveals the return on investment for a stock. It’s calculated by dividing a company’s earnings per share by its current market price per share. This article explores the definition, significance, and application of earnings yield, comparing it to the P/E ratio. We also provide examples to illustrate its real-world importance and discuss its impact on investment decisions.
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Understanding earnings yield
Earnings yield is a key financial indicator used by investors and financial professionals to gauge the attractiveness of a stock. It is defined as the earnings per share (EPS) for the most recent 12-month period divided by the current market price per share. Essentially, it tells you what portion of a company’s earnings you can expect to receive for each dollar invested in its stock.
The significance of earnings yield
Earnings yield is essentially the inverse of the more commonly known Price-to-Earnings (P/E) ratio. While the P/E ratio assesses how much you are willing to pay for each dollar of earnings, earnings yield looks at how much you can earn on each dollar invested. It serves as an indicator of value and can be an essential tool in an investor’s toolkit.
Pros and cons of earnings yield
Using earnings yield in practice
One common application of earnings yield is to compare it with the yield on risk-free assets such as the 10-year Treasury bond. If the earnings yield is higher, stocks may be considered undervalued compared to bonds. Conversely, if the earnings yield is lower, it may indicate that stocks are overvalued.
Economic theory suggests that stocks should provide a risk premium over risk-free assets due to the higher inherent risk. Earnings yield helps investors assess whether this risk premium is being met.
Earnings yield vs. P/E ratio
Earnings yield and the P/E ratio are two sides of the same coin, both providing insights into a stock’s valuation. While earnings yield is the earnings per share divided by the current share price, the P/E ratio is the current share price divided by the earnings per share.
Earnings yield may be more helpful when investors are concerned with their rate of return on investment. However, for those looking to grow their investment values over time, the P/E ratio might be a more frequently used metric.
Earnings yield and return metrics
For investors seeking stable dividend income, earnings yield becomes a valuable metric for assessing the potential return. A high earnings yield may indicate that an investment could generate significant income for investors.
Overvalued investments can lower the earnings yield, while undervalued investments may raise it. Investors should aim for scenarios where the stock price rises along with earnings to increase the earnings yield, which is particularly attractive to value investors.
Real-world examples of earnings yield
Earnings yield is not just a theoretical concept but has practical implications for investors. Let’s examine a couple of real-world examples to illustrate its significance.
Meta Platforms, Inc. (formerly Facebook)
In April 2019, Meta (META), previously known as Facebook, was trading near $175 per share with 12-month earnings of $7.57 per share, resulting in an earnings yield of 4.3%. This marked a historically high yield compared to the 2.5% or lower yield seen before 2018.
Between 2016 and 2017, the stock price surged by more than 70%, coinciding with the earnings yield increasing from around 1% to 2.5%. However, in 2018, the stock experienced a sharp decline of over 40%, while the earnings yield remained at around 3%.
The increased earnings yield likely played a role in driving the stock higher, as investors expected improved earnings in the
future. It’s worth noting that a high earnings yield (relative to prior readings) didn’t prevent the stock from experiencing a significant decline in 2018.
Using earnings yield for older stocks
Earnings yield can also be valuable when evaluating older, more established stocks with consistent earnings. If a stock is expected to have low growth in the foreseeable future, a higher-than-average earnings yield may suggest that the stock is oversold and due for an upward correction.
This metric can help investors determine when it’s a good time to buy such stocks in their investment cycle. A higher-than-typical earnings yield can indicate that the stock may be undervalued, provided there haven’t been any recent negative developments within the company.
Using earnings yield for portfolio diversification
When constructing an investment portfolio, it’s crucial to assess the risk and return of each asset. Earnings yield can be a valuable tool for portfolio diversification. By comparing the earnings yield of different stocks and asset classes, investors can make informed decisions to balance their portfolio. This subheading delves into the strategic use of earnings yield in building a well-diversified investment portfolio.
Example: Portfolio allocation
Let’s consider an example where an investor is deciding between allocating funds to stocks and bonds. If the earnings yield of a basket of stocks is significantly higher than the yield on a portfolio of bonds, it may indicate that stocks are more attractively priced at that moment. This information can guide the investor in adjusting their asset allocation to potentially maximize returns while managing risk.
Earnings yield in value investing
Value investors are keen on identifying undervalued stocks with the potential for price appreciation. Earnings yield aligns with the principles of value investing, as it helps investors identify stocks that may be trading below their intrinsic value. This section explores how earnings yield is applied in the context of value investing.
Example: Value investing strategy
Suppose an investor follows a value investing strategy and aims to buy stocks that are trading at a discount to their intrinsic value. They might use earnings yield as one of the key metrics in their screening process. By looking for stocks with higher earnings yield compared to others in the same industry, they can identify potential undervalued opportunities.
The limitations of earnings yield
Earnings yield, like any financial metric, has its limitations. This subheading discusses the factors that can affect the accuracy and reliability of earnings yield as an indicator of investment value.
Example: Extraordinary events
Sometimes, earnings yield may not account for extraordinary events or non-recurring factors that can significantly impact a company’s earnings. For instance, if a company reports unusually high earnings due to a one-time asset sale, it can distort the earnings yield. Investors need to exercise caution and consider such exceptional circumstances when relying on earnings yield for investment decisions.
Comparing earnings yield across industries
Different industries have varying levels of earnings yield due to their distinct characteristics and business cycles. This section highlights the importance of comparing earnings yield within the same industry to make meaningful assessments of a stock’s value.
Example: Technology vs. utilities
For instance, the technology sector might have lower earnings yields compared to more stable and mature industries like utilities. Investors interested in the technology sector should be aware that lower earnings yields are typical for these growth-focused companies. Comparing technology stocks within the sector allows for a more accurate evaluation, rather than comparing them to utility stocks, which have different risk and growth profiles.
Conclusion
Earnings yield is a valuable metric for investors seeking to assess the potential returns and valuations of stocks. By understanding the concept and its implications, investors can make more informed decisions when considering their investment portfolios.
Frequently Asked Questions
What is the primary difference between earnings yield and the P/E ratio?
Earnings yield and the Price-to-Earnings (P/E) ratio differ in their approach. While the P/E ratio assesses how much you need to pay for each dollar of earnings, earnings yield calculates how much you can earn on each dollar invested. Essentially, earnings yield provides a perspective of potential return on investment, while the P/E ratio focuses on the cost of earnings.
Is a high earnings yield always a positive indicator for a stock?
Not necessarily. A high earnings yield can be positive, but it must be considered in the context of the stock’s historical performance and growth prospects. A high earnings yield may indicate undervaluation, but it can also suggest that the stock’s earnings have not been growing. It’s essential to evaluate other factors, such as the company’s growth potential, to make an informed investment decision.
How does earnings yield influence portfolio diversification?
Earnings yield is a valuable tool for portfolio diversification. By comparing the earnings yield of different stocks and asset classes, investors can make decisions to balance their portfolio. If a basket of stocks has a significantly higher earnings yield compared to bonds, it may suggest that stocks are more attractively priced at that moment, potentially impacting asset allocation.
Can earnings yield be used for older stocks with stable earnings?
Yes, earnings yield can be useful for evaluating older stocks with consistent earnings. If a stock is expected to have low growth in the foreseeable future, a higher-than-average earnings yield may suggest that the stock is oversold and due for an upward correction. This metric can help investors identify opportune moments to invest in such stocks.
What are the limitations of using earnings yield as an investment indicator?
Earnings yield has limitations. It may not account for extraordinary events or non-recurring factors that significantly impact a company’s earnings. For instance, a one-time asset sale could distort the earnings yield. Investors should exercise caution and consider such exceptional circumstances when relying on earnings yield for investment decisions.
How does earnings yield apply to value investing?
Earnings yield aligns with the principles of value investing. Value investors seek undervalued stocks, and earnings yield helps identify stocks that may be trading below their intrinsic value. By comparing the earnings yield of stocks within the same industry, value investors can identify potential undervalued opportunities. This metric aligns with the core tenets of value investing.
Key takeaways
- Earnings yield is the earnings per share divided by the share price.
- It is the inverse of the P/E ratio.
- Earnings yield helps assess a stock’s value and potential returns.
- Consider the growth prospects of a company when using earnings yield.
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