The Earnings Yield is a metric used by investors to assess the investment in a company relative to other companies and assets such as fixed income (bonds or treasury bills). The earnings yield is the reciprocal of the P/E ratio
The Earnings Yield is a metric used by investors to assess the investment in a company relative to other companies and assets such as fixed income (bonds or treasury bills). The earnings yield is the reciprocal of the P/E ratio and indicates the money earned by the company relative to dollars invested in the stock.
Earnings Yield Formula
The earnings yield is calculated by dividing the earnings per share for the most recent 12-month period by the current share price. The ratio is then converted to a percentage.
A variant on the earnings yield is the projected earnings yield. This figure uses the mean estimated (projected) net earnings for the current year, next year or combination of both current and next. The estimated earnings are provided by analysts from various financial publications.
Application of Earnings Yield
Analysts often compare the earnings yield of the S&P 500, NYSE or other broad equities market to the interest rates offered on other assets, such as the 10-year Treasury yield or long term Treasury Bonds. Generally, the earnings yield of equities are higher than for fixed income assets, reflecting the added risk involved with equities. After accounting for risk, the yield between the two assets should be similar. If not then the securities market is considered either over or undervalued.
The earnings yield may also be used as a value metric by comparing the yield of one company to another. This is typically done by quantitative analysts and value investors.
Earnings Yield Quantitative Analysis
Good quantitative factors exhibit relationships with stock returns that not only have a fundamental and/or theoretical basis for stock returns but are also stable and persistent over time. The Earnings Yield is such a factor, having been correlated with past stock returns for many years and also expected to be correlated with future returns.
In the world of quantitative analysis, the investment horizon is referred to as "rebalance period", indicating the period of time a stock is held before refreshing the portfolio holdings. While some quantitative factors achieve good results with weekly, monthly or quarterly rebalance, the earnings yield typically requires an investment horizon of at least 1 year to exhibit "good" results.
The Quantitative Analyst assesses individual stock factors by:
- separating the stocks into quintiles (or deciles) based on the value of the factor
- calculating the performance of each quintile based on rebalance period and total back-test period
- analyzing the spread of performance between Quintile 1 to Quintile 5
Ideally the performance spread should be "monotonic", meaning that Quintile 1 outperforms Quintile 2, Quintile 2 outperforms Quintile 3, and so forth.
Using the above process, Earnings Yield was evaluated ed for the stocks from the Russell2000 Index over the 10 year back-test period 2005-2014 with a 1 year rebalance. The results, expressed in annualized percent profit, are shown in the figures below.
From the above column chart, it can be seen that the Earnings Yield quintiles exhibit monotonic behaviour. However, the spread of performance between Quintile 1 and Quintile 5 does not compare to other value factors such as the Price/Cash Flow Ratio.
In Quantitative Analysis, single factor back-tests are not executed to generate real-life performance figures or to outdo a benchmark. At this stage the Technical Analyst is simply trying to identify whether the stock factor contains useful predictive value. There are many other considerations involved in the construction of a portfolio that will change the performance numbers.