By JLP | March 10, 2006
In his book, The Little Book That Beats the Market, Joel Greenblatt talks about a company’s earnings yield. Most of us are familiar with the P/E ratio which is simply the share price divided by earnings per share. The P/E ratio tells us how much we are paying for each dollar’s worth of earnings. So, if a company has a P/E of 10, we are essentially paying $10 for $1 worth of earnings.
The earnings yield is simply the earnings per share divided by the price per share or the INVERSE of the P/E ratio. So, if a company has a P/E of 10, we can take the inverse of 10 (which is the 1/x key on a calculator or simply 1 ÷ 10 which equals .10 or 10%). Joel Greenblatt likes to compare a company’s earnings yield with the yield on fixed income investments so that investors get an idea of how much they are paying for a stock. Of course comparing a stock’s earnings yield to the yield on a bond can be dangerous because bonds are typically less “risky” than stocks. When you buy a high quality bond with a particular yield, you stand a good chance of getting that yield until the bond matures. With stocks, there are no guarantees. A company’s earnings per share can jump all over the place.
Anyway, it is an interesting way to look at stocks. The higher the earnings yield the more undervalued a stock looks. WARNING: A high earnings yield is only a starting point for looking at stocks.