September 16, 2014

Earnings Yield as a Value Investing Strategy

Many famous portfolio managers that practice a value investing strategy have said they think of stocks as “equity bonds”.  Instead of receiving a fixed rate of return, like you would when you buy a traditional bond, you receive a variable return based on the company’s underlying profit. 

This approach makes it easier to value a business.  The most common starting point for the valuation process is calculating a financial ratio known as earnings yield.  In this article, you will learn what the earnings yield ratio is, how to calculate it, and why it is important to so many value investors.

Personally, I like to think of it as “valuation lite” because it can provide a sense of how cheap or expensive a business or stock is, but you are still left with the problem of whether or not the earnings are of high quality (rather than simply accounting magic) and what your expectations are for the underlying economics of the business.

Understanding the Earnings Yield Ratio and What It Means

The earnings yield ratio basically tells you, “If this stock were a bond, how much would it earn as a percentage of my investment based on this year’s after-tax profits?”  It is the inverse of the price-to-earnings ratio, or p/e ratio as it is more commonly known.

How to Calculate the Earnings Yield Ratio

There are two ways to calculate the earnings yield ratio:

Earnings Yield Stock Valuation

Earnings yield is a stock valuation tool that some investors prefer to use. Earnings yield is the inverse of the price-to-earnings ratio, or p/e ratio. Image © iStockphoto/Thinkstock

1.) You can calculate the earnings yield ratio by taking net income divided by the purchase price:

Earnings Yield = Net Income ÷ Purchase Price

2.) You can calculate the earnings yield ratio by dividing 1 by a stock’s p/e ratio

Earnings Yield = 1 ÷ P/E ratio of stock

Both calculations should result in the same earnings yield so it doesn’t matter which you use.

Sample Earnings Yield Calculations

Many times, the best way to understand a new concept is to work through several examples.  Imagine you bought a regional soft drink company for $20 million that earned $2 million in net income.  In this case, the earnings yield would be 10% ($2 million net income divided by $20 million purchase price = 10% earnings yield).  Alternatively, imagine that you were looking at shares of an oil company trading at $25 with a p/e ratio of 8.  The earnings yield would be 12.5% (1 divided by 8 p/e ratio = 12.5% earnings yield).

How to Use Earnings Yield as a Value Investing Strategy Tool

Benjamin Graham once recommended investors never buy a stock that had a p/e ratio higher than the sum of the earnings yield plus the growth rate. In other words Graham said you were unlikely to experience severe losses on a well diversified portfolio if you never paid more than the following formula:

P/E Ratio < Earnings Yield + Growth Rate

Interestingly enough, this is very closely related the famous PEG ratio that Peter Lynch, the most successful mutual fund manager of all time, used to help achieve his nearly 30% compounded growth rate during his run of more than a decade at the flagship Fidelity Magellan fund. Lynch’s formula was even more conservative, stating that a good value investing stock was one where the earnings growth rate was equal to or less than the p/e ratio.

In practice, let’s say you wanted to buy shares of a pharmacuetical company that had a 5% earnings yield and was growing at 5%.  The balance sheet was strong and you expected growth to actually accelerate based on the product pipeline.  In this case, if you could buy the shares at a price-to-earnings ratio of 10 or less, you would have a reasonable chance for very satisfactory returns (5% earnings yield + 5% growth rate = 10 p/e ratio maximum).

If you can’t find a lot of candidates, don’t fear.  The reason the earnings yield approach works is because you will likely reject 98% of stocks you consider.  This is a good thing, not a bad thing.  Think of yourself as an insurance underwriter, putting together a collection of policies.  Your job is to eliminate those that don’t have a chance of earning your minimum acceptable rate of return.

  • http://www.adamvrobinson.com Adam

    Joshua,

    Great article about using a VERY important investing metric. What do you think of the “magic formula” which uses Return on Capital (ROC) ratio and earnings yields, to find stocks?

    I am a value investor, but have not been following the markets as close lately. Looking to get back to paying more attention and getting more active managing accounts.

    I am hoping to find out what your investment returns have been over the past decade? How have you done and can you reflect on some mistakes you made as well as some great trades you have made in the last decade? I feel it would give the readers a great insight how you practice what you preach. Its been a roller coaster of a decade, so it would be very entertaining to hear from you about this.

    Thanks,

    Adam

    • http://www.joshuakennon.com Joshua Kennon

      Adam,

      You have no idea how badly I’ve wanted to do exactly that – I’m human and I certainly have an ego – but we’ve never disclosed the details of the company’s portfolio in full because everything is run from within the privately held companies that own the operating businesses. That would let our competitors get an idea of where our capital levels are – well, the smarter ones anyway – because they can look at the total raw materials we use in manufacturing to estimate our volume and profit margins, which would let them know the original cash we had to play with. Add to that a compounding rate and … well, we just gave away the financial statements.

      As much as I’d love to share, I want to crush them more. For example, when the volatility index hit a high and we jumped head first into the derivatives markets by buying and selling stock options en masse, it was through a division of Mount Olympus Awards, LLC and another business that I’d rather not name.

      So, believe me: One of these days, when I sell the companies or take them public so I can’t hide the data anymore, I’ll put it all out there. I’ve been saving all of the trade confirmations going back to my teenage years for that day – somewhere in a file cabinet I think I might even have my very first stock trade paperwork. Likewise, if and when I ever decide to accept outside capital in a hedge fund form or launch a mutual fund, or something, I’ll publish it all, as well for no other reason than 1.) It will make it much easier to raise capital and 2.) like I said – I’m human and I have an ego. It will be nice to be able to trumpet it from the rooftops.

      But for now, given that I refuse to take on outside money there is zero incentive for me to publish those figures but very real consequences competitively. What possible motivation would I have for doing so? Ego alone isn’t enough, not if it is going to hurt my pocketbook.

      Still, I like being able to answer peoples’ questions so one way I decided to get around this was a suggestion from another reader, Frat Man: I’m going to go back through and try and find some of the “best ideas” and “worst ideas” from the past decade and write about them specifically, including the reasons I calculated intrinsic value the way I did. That way people can see the things that made us our money as well as the ones where we really screwed up (thankfully those have been rare but they do exist).

      Although, realize that I have a somewhat unfair advantage (although I designed my business life after companies like Allegheny, Berkshire and Loews so it really isn’t “unfair” because anyone could if they wanted) … we have private operating businesses not just marketable securities. That means that if the market crashes, we aren’t stuck with a fixed portfolio but can redeploy earnings from the companies to buy more shares when things are cheap. A few years ago, for example, when the world melted down we shut down corporate reinvestment and instead poured money into buying every share we could get our hands on of companies like GE, U.S. Bancorp, Wells Fargo, Berkshire Hathaway, CBRL, Harley Davidson, and a host of other firms that got destroyed. We were even buying Bank of America at like $4 per share at one point. When things recovered, we sold a ton of it and strengthened the balance sheet at the manufacturing business.

      Given that Aaron and I started the first company less than a decade ago with less than $5,000 invested between the two of us and everything flowed out of the profits from that – the rate is going to be damn near astronomical. (Well … nearly everything flowed from that. I still had all of my personal money in retirement and brokerage accounts built up from saving almost everything I earned since childhood.)

      Part of that is strategy: For example, we signed a contract with a local firm that, in exchange for developing their software system, we got 5% of their sales. That is going to add six-figures in profit this year for a few hours of work each month. You go around collecting streams of earnings like that with no capital cost against them and it changes the reported metrics significantly.

      So it is grossly unfair to a plain vanilla money manager to compare his returns to ours given our structural advantages. He (or she) isn’t operating with the same ground rules I am, can’t go out and borrow money to expand a business, etc. There is no way they could attempt to match the gains using the parameters that have been set for them given our ability to create private market value. That is, if we invest $10 and generate a $2 increase in profits, at a 10x capitalization rate, we’ve created $20 in private market value, or a 100% return. Some guy running a small wealth management firm cannot do that by just buying stocks and bonds.

    • http://www.joshuakennon.com Joshua Kennon

      P.S. I forgot to answer your question about “the magic formula”.

      I believe it is a brilliant back-door application of buying the greatest “owner earnings” for the lowest price. Back in the 70′s, Buffett himself had a formula for owner earnings, which he used in valuation, that included cash that could be taken out of a business without hurting the firm’s competitive position. It included reported net income + depreciation and amortization +/- LIFO adjustments + required working capital – maintenance capital expenditures to maintain current output then compared to total non-leverage equity.

      It’s almost the same system, the “formula” just guesses by looking at a few metrics and manages to collect several of these in a portfolio that is shuffled each year whereas Buffett went through them line-by-line.

      • Nicolas Rejeili

        Hey Joshua,

        I’ pretty new at investing and read your article. It was great and really helped me alot. I have been reading alot and learning on my own about the stock world. I even created a whole binder with everything like intrinisc formula, indicators, definitions and etc. My question to you is, the article above mentions  “P/E Ratio < Earnings Yield + Growth Rate." will give you an idea if this stock is a good choice for investing, but I am having a hard time finding the growth rate. If I can't find it on any site, what simple calculation can I do to find this number out and for how long of term? 1 year, 2 years, 5 years?

        Sorry it's a somewhat unintelligent question, but I am still new at all this, and want to get a good grasp of everything before I start investing.

        Thanks alot and look forward to hearing from you

        Nick

        • Joshua Kennon

          Theoretically, you could look at growth over the past 5-10 years but that doesn’t tell you much because a horse and buggy manufacturer would have had decent growth up until the time the car came along and put it out of business.

          The investor’s job is to try and estimate a conservative rate of growth for the diluted earnings per share. Let’s say you were thinking about investing in a lemonade stand.

          You know what … this deserves its own detailed response in a mailbag question. Give me a few days and I’ll publish it.

      • Jacob

        Do you know of any sources that discuss how to account for LIFO adjustments?  I haven’t read about adjusting the owner earnings formula for this before.

        Also on that note, can you explain why you would add back working capital rather than subtracting it?  Other equations I’ve read about explain it the opposite way.

        As always, thanks so much for everything you do!

        Jacob