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: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.