What is earnings yield?

What is earnings yield?

Earnings yield is the inverse of P/E. It shows the profit a company earns per dollar you pay for its stock, calculated by dividing earnings per share by price. Use it to compare stocks to bonds.

Think of it as the stock's cash return. A 10% earnings yield means you get 10 cents of profit for every dollar you invest. That's the equity cash return, directly comparable to a bond yield. You can use it to size up stocks against bonds or other investments.

For example, if a stock trades at $20 and earns $2 per share, its earnings yield is 10%. A bond paying 6% looks weaker by comparison. But stocks carry more risk, so you'd demand a higher yield. That gap is your compensation for taking on volatility.

How to calculate earnings yield

The formula is simple: earnings yield = earnings per share / price. You can also flip the P/E ratio. A P/E of 20 gives a 5% earnings yield (1 divided by 20). Use trailing earnings from the most recent four quarters.

Trailing vs forward earnings yield

Two inputs feed the same formula, and they answer different questions. Trailing earnings use the last four quarters of actual results, the most factual number available. Forward earnings use next year's projected profit, which bakes in expected growth but also analyst guesswork.

The two can disagree sharply. A fast-growing company might show a low yield on trailing earnings and a far higher one on forward numbers. Neither is wrong. Use trailing to confirm what is real today, forward to weigh what the market expects tomorrow.

Earnings yield vs bond yield

The whole point of earnings yield is to compare to bond. A bond pays a fixed interest rate; a stock's earnings yield shows what the company earns relative to its price. If the stock's yield is higher, you're paid more for the risk, but that extra return isn't guaranteed.

The Fed model uses this idea, comparing the S&P 500's earnings yield to 10-year Treasury yields. When stocks yield more than bonds, they look cheap; when bonds yield more, they pull money away. It's a rough guide, not a crystal ball.

Earnings yield vs dividend yield

Do not confuse the two. Earnings yield divides total profit by price, whether that profit is paid out or kept. Dividend yield divides only the cash you receive by price. One company can show a strong earnings yield and a thin dividend yield because it reinvests nearly everything it earns.

That gap matters. A high dividend yield is cash in your account today. A high earnings yield can still pay you nothing for years if the company plows profit back into growth. Earnings yield shows the engine's power. Dividend yield shows what lands in your pocket.

Greenblatt's adjusted earnings yield

In The Little Book That Beats the Market, Joel Greenblatt adjusts earnings yield so you can compare companies that carry different debt and tax loads. He uses earnings before interest and taxes, adds back depreciation, and subtracts capital spending. That gives you the true operating earnings.

Then he divides by enterprise value, market value plus debt minus cash. That penalizes companies loaded with debt and rewards those sitting on cash. It shows how expensive the whole business is, not just the stock, the raw earning power per dollar of full price.

What a normal earnings yield looks like

Since 1900, the average U.S. stock has traded near a P/E of 14. Flip that and you get an earnings yield above 7%. That is the long-run baseline to hold against today's number. When yields sit far above it, stocks look cheap.

Equities almost always yield more than risk-free Treasury bonds. That gap is the price of the volatility you accept for holding stocks. Part flows to you as dividends; the rest stays inside the company as retained earnings. Both build your future stake.

What does a high or low earnings yield mean?

A high earnings yield signals you get more earnings for each dollar you pay, a sign the stock may be undervalued. A low yield says the opposite, that you pay a rich price for each dollar of profit and the stock looks overvalued.

But that reading is only a starting point. A low yield can simply mean the market expects fast growth ahead and is pricing it in now. A high yield can flag a struggling firm that no one trusts. Context decides which story the number tells.

Earnings yield is most useful when you compare across close peers. Two similar companies in the same sector, one yielding 8% and one yielding 4%, point to very different prices for similar profits. That gap is where opportunity hides.

It works best on mature businesses with stable earnings. A young high-growth company can show a yield that swings wildly with forecasts. A staid dividend payer gives a steadier reading you can trust as a comparison baseline.

Limitations of earnings yield

Earnings yield has flaws. Earnings per share can swing, making the yield unstable while bond yields stay fixed. It also ignores debt and taxes, so a heavy-debt company can still look attractive. Adjusted versions factor in interest, taxes, depreciation, and enterprise value.

The bottom line

Earnings yield is a simple tool. It flips the P/E ratio to show you the return per dollar. Use it to compare stocks to bonds. Just remember it's based on earnings, not cash paid out. Always pair it with other metrics before you invest.