Earnings yield, also known as the price-earnings ratio, is a ratio used by investors to assess the value of a stock. It is calculated by dividing a corporation’s earnings per share by the current share price and expressed as a percentage. Investment managers consider high returns as undervalued and low returns as overvalued, but other factors such as potential growth and prevailing interest rates must also be taken into account.
Earnings yield is a measurement ratio often used by investment managers or stock market investors to assess the value of a particular stock. The earnings yield is equal to a corporation’s earnings per share divided by the current share price. In this context, the term “earnings per share” simply refers to the amount of new earnings attributable to each outstanding share of the corporation’s common stock. Earnings per share is generally calculated based on the value of the share over the last twelve month period.
Also known as the price-earnings ratio, the performance-earnings ratio is abbreviated as E/P, and is usually expressed as a percentage. For example, if a corporation’s earnings per share for the past twelve months equals $5 US Dollars (USD) and the share price is $50 USD, the E/P ratio is 50/5. Expressed as a percentage, the earnings yield on that corporation’s stock equals 10%.
The earnings yield ratio is the inverse of another commonly used stock measurement ratio: the price/earnings (P/E) ratio. The P/E ratio is equal to the current price of a share divided by its earnings per share. Some market testers prefer to use the E/P ratio because, unlike the P/E ratio, it is expressed as a percentage. This can make it easier to compare a stock’s earnings with the returns of other types of investments, such as bonds or money market instruments.
When E/P ratios are used to evaluate stocks, investment managers consider whether a corporation’s stock exhibits high earnings performance or low earnings performance. As a general rule, a high return suggests that a stock is undervalued, while a low return may indicate an overvalued stock. This rule is not absolute, and financial evaluators must take other factors into account as well.
One factor that should also be weighed when reviewing earnings performance is the performance of the stock for future periods. An E/P ratio looks at the shares over a one-year period and consequently does not take into account the actual value of the shares for future periods. The potential growth of the stock must also be taken into account. Some stocks may show minimal gains to date, despite having strong growth potential. As a result, while these stocks may not be overvalued, they may indicate underperformance in earnings.
Investment managers can look more generally at how earnings performance relates to prevailing interest rates. This is done by weighing the earnings performance of a broad market index against prevailing interest rates. If the earnings yield is lower, stocks may be considered overvalued compared to bonds.
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