Peak earnings are a common value investing trap that most often hurts inexperienced investors who look only at the earnings per share and not the underlying driver of those profits. The last big round of peak earnings value traps occurred at the end of the housing bubble. By knowing what to look for, you’ll be better equipped to spot value traps, lowering the chances your portfolio will be damaged by them.
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.