Earnings Yield is an important concept to understand because it is absolutely vital to begin understanding stock pricing; it is the reason why a $2 stock may be more expensive than a $2,000 stock. To understand earnings yield we look at a commonly known and easy to find metric called the P/E Ratio:
P/E Ratio = (Price Per Share) / (Earnings Per Share)
The P/E Ratio tells you a number of important things; assuming EPS stays the same, it represents the number of years that it would take to return your purchase price to you through earnings. The current market average is about 20, but you will notice regularly some stocks like Visa (V) that have high P/E’s like 75.53, and others like Chevron (CVX) that have a P/E of 8.82. Usually, a stock’s P/E ratio is higher if the earnings of a company are expected to grow, and lower if they are stagnant or shrink.
Benjamin Graham argued that the highest P/E Ratio a defensive value investor should even consider is 13.5. However, a lot has changed in the 70 years since he published The Intelligent Investor, and modern companies have much higher efficiency rates due to increases in technology and globalization – usually warranting higher P/E’s.
Related to the P/E Ratio is the Earnings Yield (%):
Earnings Yield = 1 / (P/E)
For example, the earnings yields of Visa (V) and Chevron (CVX) are 1.32% and 11.34%, respectively. The earnings yield tells you the percentage rate of return the company made in terms of profit per dollar paid to acquire the share. This ratio makes a startling difference when you look at how this affects your investments. Say that you invested $100,000 in both of Visa (V) and Chevron (CVX), you would earn a paltry $1,320 of look-thru earnings from Visa, and a whopping $11,340 from Chevron.
A common rule of thumb is that you should generally not purchase an investment that has an earnings yield of less than 1.5x the prevailing 30-year treasury rates. Currently, the 30 year yield is 2.87%, so the smallest earnings yield we should look for is 4.31%, which corresponds to a maximum P/E ratio of 23.2. Based on treasury rates we can see that the market is overall pretty fairly valued. If you want to be more conservative, you can look for double the treasury rate, which would give us a minimum yield of 5.74%, or a maximum P/E of 17.4.