What is Earnings Yield?
The earnings yield represents the earnings per share (EPS) for the most recent 12-month period divided by the current market price per share. This ratio, the inverse of the Price-Earnings (P/E) ratio, reveals the percentage of a company’s earnings per share. By providing insight into a company’s earnings relative to its stock price, it serves as a crucial indicator in determining whether a stock is underpriced or overpriced, aiding both investors and investment managers in optimal asset allocation.
Key Takeaways
- Earnings yield is calculated as the 12-month earnings divided by the share price.
- It acts as the inverse of the P/E ratio.
- A low earnings yield may suggest an overvalued stock, whereas a high yield may indicate an undervalued stock.
- Growth prospects should be considered when evaluating earnings yield; high growth potential often equates to higher valuations and lower yields.
How Earnings Yield Works
Investors frequently compare the earnings yield of a comprehensive market index (such as the S&P 500) to current interest rates, like the 10-year Treasury yield. When the earnings yield falls below the 10-year Treasury yield, equities may be seen as overvalued, and when it rises above, they may be considered undervalued relative to bonds. Economically, equity investors should require a risk premium exceeding risk-free rates to compensate for the higher risk of stocks versus bonds.
Earnings Yield vs. P/E Ratio
Though earnings yield is an essential valuation metric, it isn’t as widely used as the P/E ratio. While the P/E ratio is a conventional tool for stock valuation, earnings yield is particularly useful when gauging return on investment. Investors primarily focused on long-term value appreciation may favor P/E ratios over earnings yield. Both, however, provide similar insights presented differently.
Earnings Yield as a Return Metric
For investors seeking reliable dividend income, earnings yield offers a transparent view of potential returns from dividend stocks. It stands as a return metric (illustrating potential income) rather than just a valuation metric. Notably, the stock’s valuation directly impacts earnings yield: Overvalued stocks exhibit lower yields, while undervalued stocks display higher yields. Value investors prefer investments where earnings yield increases as a result of price stabilization or earnings growth.
Inspirational Case Study: Earnings Yield in Action
Earnings Yield In 2019: Meta’s (formerly Facebook) Case Study
In April 2019, Meta’s stock traded around $175, boasting 12-month earnings of $7.57 that resulted in an earnings yield of 4.3%. Comparatively, this yield was historically significant as it had previously lingered around 2.5% or lower pre-2018. As the stock price saw a significant rise between 2016 and 2017, the earnings yield correspondingly amplified from 1% to 2.5%. After a dip that caused the stock to lose over 40% off its 2018 high, the earnings yield escalated, hovering near record levels of about 3%. By early 2019, the yield climbed above 5% as the stock price began to recover. This substantial increase in earnings yield likely attracted investors, spurring stock price resurgence amidst expectations of improved earnings.
Earnings yield is equally compelling when applied to mature companies with steady earnings. In these scenarios, a higher-than-usual earnings yield may signal an opportune moment to invest, suggesting the stock is oversold and potentially poised for a rebound, provided no significant negative developments occur.
Related Terms: Price-Earnings Ratio, Earnings Per Share, Asset Allocation.
References
- Nasdaq. “FB Revenue EPS”.
- Yahoo Finance. “Meta Platforms, Inc. (FB)”.
