What is Earnings Yield?
The earnings yield is a financial ratio that describes the relationship of a company’s LTM earnings per share to the company’s stock price per share. The earnings yield is the inverse ratio to the price-to-earnings (P/E) ratio. The quick formula for Earnings Yield is E/P, earnings divided by price. The yield is a good ROI metric and can be used to measure a stocks rate of return.
Explaining Earnings Yield
Essentially, earnings yield shows how much earnings per share a company generates from every dollar invested in the company’s stock. Unlike its P/E ratio counterpart, earnings yield cannot provide any insight into the stock’s valuation. Instead, it is typically used by investors in assessing their investment’s rate of return. The ratio can be particularly valuable when comparing potential returns among different securities.
In some cases, the earnings yield is used to calculate the dividend payout ratio. Recall that the dividend payout ratio indicates the proportion of the company’s earnings that is distributed as dividends to its shareholders. The dividend payout ratio can be calculated using the earnings yield and dividend yield. In this case, the formula is:
Nevertheless, as a measure of financial returns, the earnings yield still comes with a few significant drawbacks. For instance, the ratio may be extremely volatile due to fluctuations in the earnings per share (EPS). Also, it can be used only as an indicative return as the actual returns generally diverge significantly.
Formula for Earnings Yield
Mathematically, the formula to calculate the earnings yield is expressed in the following way:
In addition, there is an adjusted version of the formula that accounts for differences in the capital structure and tax rates between companies. The adjusted formula for calculating the earnings yield is:
John holds an equity portfolio. Recently, he’s identified two stocks that can be added into his portfolio, but John can only select one of them.
The first option is the stock of ABC Corp. that is currently traded at $8 per share while the company’s earnings per share (EPS) for the last twelve-month period were $0.35 per share. On the other hand, the stock of XYZ Corp is trading at $45 per share with its earnings per share (EPS) for the same period were $0.65 per share.
John can select the most suitable stock that can be added to his portfolio by comparing the returns of the two stocks using the earnings yield. Thus,
The calculations above show that every dollar invested in ABC Corp.’s stock generates 4 cents while every dollar invested in XYZ Corp.’s stock generates only 1.4 cents.
CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful: