Earnings Yield

What is a Good Earnings Yield?

Often the earnings yield is often used as a tool to determine whether a company’s shares are undervalued or overvalued by the market.

• Lower Earnings Yield (%) → Shares might be overvalued at the moment at their current market price
• Higher 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 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 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 its industry peers, which helps establish the right baseline to use as a point of reference.

Similar to the P/E ratio, the yield metric 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 vs. Bond Yield

While a sizable portion of investors make 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’s 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 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.

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).

Earnings Yield Calculator

We’ll now move on to a modeling exercise, which you can access by filling out the form below.

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1. Market Share Price and Shares Outstanding Assumptions

To start, we’ll list out the assumptions that we’ll be using in our example calculation.

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

2. Earnings Yield Calculation Example

So far, we have been 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 the necessary inputs for calculating our two metrics – for example:

• Company A E/Y = $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 yield can also be calculated by:

• Company A E/Y = 1 / 12.5x PE Ratio = 8.0%

Just like the first method, we once again get 8.0%.

3. Earnings Yield and P/E Ratio Analysis Example

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 our training exercise is the inverse relationship between the earnings yield metric 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 yield tends to increase, whereas their P/E ratios gradually normalize to sustainable levels.