Imagine you are considering investing money, whether in buying property or purchasing stocks. Naturally, you want to ensure you get a good return on your investment.
This is where understanding ‘yield’ becomes important. Yield tells you how much profit you are making from your investments.
Now, let us look at a specific type of yield called ‘earnings yield’, and how it can help you assess the profitability of a company's stock.
What is earnings yield?
Earnings yield is a way to measure how much profit a company’s stock has provided to an investor. For example, if the earnings yield of a company is 15%, it means that investors have earned Rs. 15 for Rs. 100 worth of shares they own.
So, if a company has a high earnings yield, it means you are getting a bigger piece of its profits for every rupee you invest. It is like looking at the return on your investment each year. Instead of focusing on actual cash dividends the company pays you, earnings yield looks at the earnings investors make per share.
Formula for earnings yield
Here's the earnings yield formula:
Earnings Yield = Earnings per share (EPS) / Market price per share x 100
Earnings yield allows investors to understand if owning shares of the company will provide adequate returns. It is also a metric that experienced investors use to compare stocks and invest in the one with a higher earnings yield.
Practical example
Here is how the earnings yield ratio can be used in real life:
Imagine you are considering investing in two companies, A and B. Company A has a higher stock price than Company B, but both have the same EPS. By calculating the earnings yield, you can compare the potential return on your investment.
- Company A: Stock Price = Rs. 200, EPS = Rs. 10, Earnings Yield = 5%
- Company B: Stock Price = Rs. 100, EPS = Rs. 10, Earnings Yield = 10%
In this scenario, company B has a lower stock price but still offers a higher earnings yield, meaning that if you invest the same amount in both stocks, company B will offer a better per-rupee return.
Important note: Remember, when deciding where to invest your money, it is not just about one ratio, such as the earnings yield ratio. You also need to consider things like how fast each company is growing, how much money they are expected to make in the future, and how financially stable they are overall.
Benefits of using earnings yield
- Compares companies across industries: Earnings yield helps you compare companies even if they are in different industries. Instead of looking at specific numbers, it looks at a ratio, making it easier to see which companies might offer better returns, no matter their business operations and industry.
- Focuses on profitability: It shows how good a company is at making money and how well-priced its shares are trading on stock exchanges. This can prove to be a good metric for investors to understand whether the shares are overvalued or undervalued.
Limitations of earnings yield
- Ignoring dividends: The earnings yield ratio doesn't include the money a company pays out to its shareholders as dividends. So, a company might seem less profitable based on earnings yield, but if it pays good dividends, it could still be a good choice for people who want regular income from investments.
- Forgetting future growth: Earnings yield looks at how a company performed in the past, not how it might do in the future. So, even if a company has the potential to grow a lot, its earnings yield might be lower because its stock price already reflects the expected future earnings.
Earnings yield vs price-to-earnings ratio (P/E ratio)
Another way to evaluate stocks is by looking at the price-to-earnings ratio, or P/E ratio for short. This ratio tells us how much investors will pay for each rupee a company earns.
Here is how you calculate it. Divide the market price of a single share of stock by the earnings per share, which is how much profit each share represents.
If the P/E ratio is high, it means investors are paying a lot for each rupee of earnings, which could suggest the stock is expensive. On the other hand, a low P/E ratio might mean the stock is cheaper relative to its earnings.
The relationship between earnings yield and P/E ratio is quite simple:
- Earnings yield = 1 / P/E ratio
Therefore, a high earnings yield translates to a low P/E ratio, and vice versa.
Interpreting earnings yield
Here is a general guideline for interpreting earnings yield:
- High earnings yield (above market average): A stock with a high earnings yield might mean it is priced lower compared to how much money it is making, which could be a good sign. But it could also mean the company hasn't been doing as well financially lately, so it is important to look into more company-relevant factors such as market capitalisation or the company’s quick assets.
- Low earnings yield (below market average): If a stock has a low earnings yield, it could mean its price is high compared to its earnings, which might mean it is overpriced. However, it could also mean the company has big growth plans that investors are already counting on. Hence, a detailed analysis of the company’s future goals is crucial.
Important note: Remember, what is considered a good earnings yield ratio can vary depending on the industry and what is going on in the market. So, it is smart to compare a company's earnings yield to its past performance and similar companies in the same business.
Conclusion
Earnings yield provides valuable insights into whether a company's stock is a worthwhile investment by comparing its profit to its stock price. However, remember, it is just one part of the bigger picture. Before making any investment decisions, it is crucial to consider other financial metrics and factors.
