It’s common to examine a company’s price-to-earnings (P/E) ratio in order to get a rough idea of its valuation.
It’s also worthwhile to look at the P/E’s inverse — the “earnings yield.”
Let’s review the P/E first.
To calculate the P/E of a company, you simply divide the current stock price by the annual earnings per share (EPS).
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If its current annual EPS is $2.50 and the stock is trading for $100 per share, the P/E is 100 divided by $2.50, or 40.
While 40 may seem steep, it’s not meaningful until you compare it with the P/E ratios of industry peers and consider the firm’s health, competitive position and growth rates.
The simplest way to calculate the company’s earnings yield is to just reverse the P/E ratio, dividing the annual EPS by the current stock price.
So $2.50 divided by $100 equals 0.025, or 2.5 percent.
If risk-free Treasury-bond rates are, say, around 3 or 4 percent, this won’t seem a bargain.
But remember: Whereas bond rates are fixed, earnings typically grow.
If the company is expected to increase earnings by 10 percent per year, in 10 years its EPS should grow to $6.48.
If we bought our shares at $100, our effective earnings yield would become 6.48 percent, considerably better. ($6.48 divided by $100 is 0.0648.)
It can be instructive to see how long it takes for the growing earnings yield to pass the current 30-year bond rate, or your target rate.
If your desired rate of return for your invested dollars is 12 percent, it will take about 16 years of earnings growth before the earnings yield of the company beats that target — if earnings actually grow at the estimated pace.
You can probably find other investments that will get you there more quickly.
With riskier companies, you might look for them to pass your target rate sooner rather than later.
The earnings yield can help you think more clearly about your expectations for investments. I
t’s just one of many measures to assess.