What is Earnings Yield?
The Earnings Yield is calculated by dividing the earnings per share (EPS) in the trailing twelve months by the latest closing market share price.
As the inverse of the P/E ratio, the earnings yield measures the amount of earnings per share (EPS) that a company generates for each dollar invested into its shares.
- What formula is used to calculate the earnings yield?
- What is the relationship between the P/E ratio and earnings yield?
- What are some of the shortcomings of the earnings yield metric?
- Why is the earnings yield frequently used for comparison purposes?
In This Article
Earnings Yield Formula
For investors, the earnings yield can be informative in terms of helping you understand how much of the Company’s earnings you will be receiving for each dollar invested in the underlying company’s issued shares.
The earnings yield metric facilitates more practical comparisons among two or more public companies.
Alternatively, the earnings yield can be calculated by dividing 1 by the P/E ratio of the company.
Earnings Yield and P/E Ratio Example Calculation
For instance, if a company’s shares are currently trading at $10.00 in the open market and its diluted EPS for the latest fiscal year was $1.00, the following formulas can be used to calculate the company’s P/E ratio and earnings yield:
- Earnings Yield: $1.00 Diluted EPS / $10.00 Share Price = 10.0%
- P/E Ratio: $10.00 Share Price / $1.00 Diluted EPS = 10.0x
Therefore, given the earnings yield of 10.0%, the takeaway is that for each dollar invested into the company’s shares, the investment would generate $0.10 of EPS.
Often, the earnings yield is often used as a tool to determine whether a company’s shares are undervalued or overvalued by the market.
- Low Earnings Yield: Shares might be overvalued at the moment at their current market price
- High Earnings Yield: Shares might be undervalued and worth looking into in more detail for consideration as a new investment (or continued hold, assuming there’s further upside potential)
The historical growth trajectory, as well as a company’s future growth prospects, each represent critical factors that can impact the earnings yield metric.
Furthermore, companies with promising growth potential in the coming years are far more likely to be valued at higher valuations – which in turn, results in a lower earnings yield as their share price increases (i.e. the market is pricing in the improved monetization of existing and new customers).
When determining the right parameters (i.e. undervalued, overvalued, or priced accurately by the market), it is best to start by performing background research on the company to understand the actual underlying drivers.
From doing so, you’ll obtain a much better understanding of the company’s fundamentals and that of industry peers, which helps establish the right baseline to use as a point of reference.
The earnings yield – similar to the P/E ratio – tends to be the most informative when it comes to mature companies in the later stages of their growth cycle and those with many close competitors.
Earnings Yield vs Dividend Yield
While a sizeable portion of investors makes investment decisions using the amount and growth of dividends paid as a proxy for value, earnings are the real long-term driver of dividend payments (and the firm valuation – i.e. share price).
At the end of the day, dividends come out of the retained earnings of a company. Therefore, it can be argued that the earnings yield is a more practical metric for evaluating potential investments, which is attributable to the fact that not all companies issue dividends.
Additionally, many underperforming companies can be hesitant to cut dividends and choose to sustain a high payout for the sake of maintaining their current share price. In such scenarios, the irrational behavior of management teams could paint a false picture of the financial health of the company.
Earnings Yield vs Bond Yield
Similar to the yield on bonds and other fixed-income instruments, the earnings yield is expressed in the form of a percentage.
The earnings yield is often touted as being most useful for comparability between equity instruments and bonds and other fixed-income instruments – for example, imagine comparing a company’s P/E ratio to the yield on 10-year treasury notes (i.e. the risk-free asset).
Excel Template Download
Now, we’re ready to go through a simple exercise of calculating the earnings yield. To access the file, fill out the form linked below and follow along.
Earnings Yield Assumptions
To start, we’ll list out the assumptions that we’ll be using in our example calculation of the earnings yield.
First off, we’ll have two companies, Company A and Company B, both sharing the following assumptions:
- Latest Closing Share Price: $25.00
- Weighted Average Diluted Shares Outstanding: 50m
Now, for the one major difference between the two companies:
- Company A Net Income: $100m
- Company B Net Income: $20m
With that said, for both companies we can calculate their diluted EPS:
- Company A Diluted EPS: $100m Net Income / 50m Diluted Shares = $2.00
- Company B Diluted EPS: $20m Net Income / 50m Diluted Shares = $0.40
Earnings Yield and P/E Ratio Calculation
So far, we were given the latest share price for each company, and we just calculated the diluted EPS using the provided net income and diluted share count assumptions.
We now have all of the necessary inputs for calculating the earnings yield, as well as the P/E ratio.
Earnings Yield and P/E Ratio Formulas
To reiterate from earlier, the following formulas will be used to calculate the earnings yield and P/E ratio:
- Earnings Yield = Diluted EPS / Latest Closing Share Price
- P/E Ratio = Latest Closing Share Price / Diluted EPS
For example, Company A’s earnings yield can be calculated using the below:
- Company A Earnings Yield = $2.00 Diluted EPS / $25.00 Share Price = 8.0%
And then, the P/E ratio of Company A can be calculated using the formula below:
- Company A P/E Ratio = $25.00 Share Price / $2.00 Diluted EPS = 12.5x
Alternatively, the earnings yield can also be calculated by:
- Company A Earnings Yield = 1 / 12.5 PE Ratio = 8.0%
Just like the first method, we once again get 8.0% for the earnings yield.
So based on our calculations, Company A has the following metrics:
- Earnings Yield = 8.0%
- P/E Ratio = 12.5x
On the other hand, Company B has the following metrics:
- Earnings Yield = 1.6%
- P/E Ratio = 62.5x
In closing, the key takeaway from this exercise is the inverse relationship between the earnings yield and the P/E ratio.
The higher the P/E ratio, the lower the earnings yield – but it is important to understand that this does not necessarily imply that the company is overvalued.
The low earnings yield and high P/E ratio can signal that investors expect significant profit margin improvements and are thereby pricing those positive expectations into the market price.
Gradually, as companies mature in their respective markets and establish their competitive positioning over time, the earnings yield tends to increase whereas their P/E ratios gradually normalize to sustainable levels.