Earnings yield is the inverse of price-to-earnings (P/E) ratio.
Investors have a couple of basic choices when it comes to putting their money to work. They can buy bonds and earn the yield (interest) from those bonds. That's a known quantity. Or, they can buy stock and have a claim on the earnings of the company and, even, receive some of those earnings in the form of dividend payments. But how to know which one is better?
One way is to use the earnings yield. As a share holder, you have a claim on the earnings of the company. But what is that claim as a portion of your investment? The earnings yield tells you. Divide the earnings per share (EPS) by the share price when you bought. The result is the earnings yield and is just the inverse of the P/E ratio.
So, if the company earned $1.00 per share and you bought at $18.00, then the earnings yield would be $1.00 / $18.00 = 0.055555 = 5.56%.If your choice was between that and a bond yielding 6%, then the bond could be said to be the better investment, on a yield basis.
Of course this is not the actual return on the investment, just the claim on earnings expressed as a percentage of the original investment in the company. The actual return comes from cash the company distributes to its shareholders either through dividends or [[share repurchase[[s, as well as from appreciation of the stock price.
Uses of earnings yield
Growth of earnings yield
Remember that at a growing company worthy of your investing dollars, the earnings will also grow. This will increase the earnings yield on your original investment as time passes. If the company grows earnings at 10% per year, then after five years, the above company would have an EPS of $1.61 and the yield on the original $18 purchase would be 8.94%. Bonds do not have this characteristic, as they will always pay a constant amount each year. The yield is fixed.
This difference can be used to determine how long it would take in order for the earnings yield to surpass the yield of a bond, if the one starts below the other. For the same hypothetical situation, the stock would have an earnings yield above 6% after only one year.
Low P/E stocks
From the simple math of earnings yield, it is obvious that a low P/E will have a high yield, and vice-versa. In other words, the share holder has a larger claim upon the earnings of the company when the price for the company is lower.
Contrariwise, when the P/E is very high, then the yield will be very small and it might be better to look elsewhere.
The Fed Model
The Fed Model (not endorsed by the Federal Reserve) hypothesizes that the market is in equilibrium when the earnings yield on the S&P 500 matches the yield on the 10 year Treasury note. Any dissonance in the relationship would show that equity valuations are out of whack.
For example, if the 10 year Treasury note yields 4%, the S&P 500 average P/E should be 25x (or 4% earnings yield) to be in equilibrium. If the S&P earnings yield is greater than 4%, the market is considered undervalued and stocks should be bid up until the earnings yield drops to 4%.
The Fed Model has proven valuable in some cases (1990s) and completely bunk in others (2000-2002).