Earnings Yield

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One of the most important metrics for an investment is the rate of return. If you invest in a stock, what is the expected return? The earnings yield is one measure of a stock's expected return. It tells you how much the company expects to earn for every one rupee of stock you own. If a company has an earnings yield of 10%, it means that the company expects to earn 10 rupees for every 100 rupees worth of shares owned.

The earnings yield is also the inverse of the price earnings (PE) ratio. You can think of it like an earnings price ratio. The earnings yield and the PE ratio contain the same information.

The earnings yield can be used to compare different stocks, or to compare a stock to fixed deposit. When comparing between stocks, we prefer the company with the higher earnings yield, assuming the companies are identical otherwise. We can also compare the earnings yield with the rate of return on a fixed deposit.

Assuming no capital gains, it wouldn't make sense to a buy a stock with a lower earnings yield than the return from a fixed deposit. This is because a stock is risky and can lose money. A fixed deposit gives you a guaranteed return. If the stock has a higher earnings yield than the fixed deposit, then you can determine whether the additional return is worth taking the risk.

The earnings yield suffers from similar pitfalls as the price earning ratio. If a company has a high earnings yield, it could be because its future outlook is poor and earnings are expected to fall significantly. Earnings can also be manipulated in short term, and investors must be aware of this when analyzing a company's earnings.

The Earnings Yield Formula

The earnings yield is the earnings per share divided by the market price per share. This is also inverse of the PE ratio. The market price per share is simply the stock price. The earnings per share comes from the most recent income statement. We multiply by 100% and report in percentage terms.

Earnings Yield = 100% * (earnings per share / market price per share).
Earnings Yield = 100% * (1 / PE ratio).

Calculating the Earnings Yield, An Example

Suppose Baja Auto's current stock price is Rs 3,135. And their most recent earnings per share is Rs 134. Using our formula gives us an earnings yield of 4.27%.

Bajaj Auto earnings yield = 100% * (Rs 134 / Rs 3,135) = 4.27%

Comparing Earnings Yield with Other Indicators

How does the earnings yield compare to other indicators, such as dividend yield or fixed deposit yield? The yield on a fixed deposit is simply the return from owning a fixed deposit. It is a safe and guaranteed rate of return. If you are investing in stocks, which are risky, you should expect to earn above this rate. Now, earnings yield may not be enough to determine a stock's expected rate of return. Often, an earnings yield can appear low, if the stock's earnings are expected to grow substantially. It can also appear low if you an anticipate a large capital gain from owning the stock. Sometimes the earnings yield can be of no use if a company is loss making.

The dividend yield is the percentage return on your investment coming from dividends. When a company makes a profit, it pays some of that out to investors as dividends. The rest is held as retained earnings, possibly for future investment. As a shareholder, you receive the actual dividend in your account. You do not receive the earnings yield. The dividend yield is not always comparable to the earnings yield. A fast growing company may choose to pay no dividends and reinvest all its earnings into future growth. A mature company may pay a greater fraction of its earnings as dividends. A firm has more control over its dividend yield than its earnings yield, since it chooses how much to pay out in dividends.

FAQs on Earnings Yield

1. What is the formula used to calculate earnings yield?

The earnings yield is calculated by dividing the earnings per share by the market price per share. This is also inverse of the PE ratio.

The market price per share is simply the stock price. The earnings per share comes from the most recent income statement.

We multiply by 100% and report in percentage terms.

Earnings Yield = 100% * (earnings per share/market price per share).

Earnings Yield = 100% * (1 / PE ratio).

2. Why is earnings yield important?

The earnings yield is important as it can be used to compare different stocks, or to compare a stock to a fixed deposit.

When comparing stocks, if the companies are identical, one can choose the company with the higher earnings yield.

One can also compare the earnings yield of the stock with the rate of return on a fixed deposit.

If the stock has a higher earnings yield than the fixed deposit, then you can determine whether the additional return is worth taking the risk.

However, if you assume no capital gains, it wouldn't make sense to buy a stock with a lower earnings yield than the return from a fixed deposit.

This is because a stock is risky and can lose money. A fixed deposit gives you a guaranteed return.

3. What is a good earnings yield?

Anything that is 10 basis points above the 10-year government bond yield is a good earnings yield.

However, a high earnings yield need not necessarily indicate a good investment.

Whether the stock is a good investment or not will depend on the company's other fundamental strengths and future growth potential.

Therefore, the earnings yield should be thought of as an initial check in order to find fairly valued common stocks.