What is the Earnings Yield?
The earnings yield is the ratio of a company's last twelve months (LTM) of earnings per share (EPS) to its stock price. It is the inverse of the price-to-earnings (P/E) ratio.
How Does the Earnings Yield Work?
The formula for earnings yield is:
Earnings Yield = LTM EPS / Stock Price
Let's assume XYZ Company's last twelve months of earnings total $0.75 per share. If XYZ stock is currently trading at $10.00, then using the formula above, we can calculate that XYZ Company's earnings yield is:
$0.75 / $10.00 = 7.5%
Why Does the Earnings Yield Matter?
The earnings yield is a way to measure returns, and it helps investors evaluate whether those returns commensurate with an investment's risk. For example, the investor may not feel that 7.5% adequately compensates for the added risk of owning XYZ Company stock if lower-risk stocks carry yields of 8.5%. However, a 7.5% earnings yield could be attractive if similar companies yield only 5%.
It is important to note that earnings yield does not always represent cash available to the investor, because companies may choose to reinvest earnings rather than pay dividends to shareholders. Unlike the dividend yield, earnings yield is not dependent on management's capital-allocation decisions.
Earnings yield is a critical component of the Fed Model, which evaluates whether stocks are overvalued or undervalued. However, it is only one method for evaluating investments; it is no substitute for comprehensive analysis. Even though earnings and stock prices are somewhat correlated, the price at which the investor buys and then sells a stock ultimately determines returns.