Earnings yield is a measurement ratio that is often used by investment managers or stock market investors to evaluate the worth of a particular stock. The earnings yield equals a corporation’s earnings per share divided by the current share price. In this context, the term “earnings per share” simply refers to the amount of new profits attributable to each outstanding share of the corporation’s common stock. Earnings per share are typically calculated based on the stock’s value during the most recent twelve-month period.
Also referred to as an earnings-price ratio, the earnings yield ratio is abbreviated as E/P, and is usually expressed as a percentage. For example, if a corporation’s earnings per share for the past twelve months are equal to $5 US Dollars (USD) and the share price is $50 USD, the E/P ratio is 50/5. Expressed as a percentage, the earnings yield for that corporation’s stock is equal to 10%.
The earnings yield ratio is the inverse of another commonly used stock measurement ratio: the price-to-earnings (P/E) ratio. The P/E ratio is equivalent to a share’s current share price divided by its earnings per share. Some market evaluators prefer to use the E/P ratio because, unlike the P/E ratio, it is expressed as a percentage. This can make it easier to compare a stock’s profit to yields on other types of investments, such as bonds or money market instruments.
When using E/P ratios to evaluate stocks, investment managers consider whether a corporation’s stock shows a high yield on earning or a low yield on earning. As a general rule, a high yield suggests that a stock is undervalued, while a low yield may indicate an overvalued stock. This rule is not absolute, and financial evaluators must also take other factors into account.
One factor that must also be weighed when reviewing earnings yield is the stock’s return for future periods. An E/P ratio looks at the stock for a one-year period, and consequently fails to account for the stock’s actual value for future periods. Potential stock growth must also be accounted for. Some stocks may show minimal earnings to date, despite having strong growth potential. As a result, although these stocks may not be overvalued, they may indicate a low yield on earning.
Investment managers may look more generally at how the yield in earning relates to prevailing interest rates. This is done by weighing the earnings yield of a broad market index against prevailing interest rates. If the earnings yield is lower, stocks may be considered overvalued when compared to bonds.