Earnings Yield: Valuing Stocks vs. Bonds
Joel Dresang: Kyle, investors have various ways of measuring how relatively expensive or cheap stocks are. I want you to explain one of those: That’s the earnings yield. But first, I want to talk about a more common measure, and that’s the price-earnings ratio.
Kyle Tetting: Joel, the price-earnings ratio gives us a way to understand what we’re paying for $1 worth of earnings for a company.
So take a company that has a stock price right now of $20 per share, earnings per share of $1, and very simply, you have a P/E ratio of 20.
The challenge, of course, is that that number better applies to markets more broadly. It’s useful on stocks and getting an idea of what’s cheap and expensive, but it becomes even more useful when you’re talking about it in terms of markets.
But again, it only tells us relative to history how expensive or cheap things are – or relative to other markets, other stocks how expensive or cheap things are. What we really want to know as investors is not just how cheap or expensive are stocks, but what does that look like relative to other investment alternatives that might be out there?
Joel: Right, and that’s what brings us to the earnings yield. So, that’s actually putting the price-earnings ratio on its head, right?
Kyle: Yes. So, the earnings yield is simply the reciprocal of the price-to-earnings ratio. We’re looking at earnings over price instead of the other way around.
And again, take that company with $1 worth of earnings and $20 per share: 1 over 20 is simply 5%.
What that tells us – the earnings yield of 5% – is that for every $1 I’m investing in a company, I can get five cents of earnings back. And so now all of a sudden, we have a useful tool. We can start to make some comparisons on what that five cents of earnings per $1 invested really means.
Joel: So, what do you do with that tool? How do you make those comparisons?
Kyle: One of the best comparisons we can make is to look at what a stock – or what an index – might earn on $1 of investments versus what a comparable safe investment might earn.
And one of the best things to look at is the 10-year Treasury. The government is a very safe place to invest money – especially the U.S. government – a very safe place to invest money.
So we can look at the earnings yield of an investment in an index, or a stock index, compared to the interest that you might get on a bond. And you look at that 5% earnings yield on our stock example compared to say 2% or 2.5% on what the 10 year Treasury’s earning, and all of a sudden, that 5% looks very attractive; stocks look very attractive relative to safer investment.
Joel: So, you’re comparing the yields on stocks versus bonds, but you also mentioned safety in there.
Kyle: Yes. So risk is really the key to all this because when you talk about that 2% or 2.5%, you can get on a 10-year Treasury, that’s a pretty sure thing. Again, the government backs the 10-year Treasury. The government obviously has every intention of paying back its investors.
But the earnings yield – the earnings piece is variable. It’s somewhat volatile over time. So as we talk about that 5% compared to that 2.5%, you want to make sure that that gap between the two is wide enough to support the additional risk you’re taking.
We know that investors are risk averse and we’re not going to take risk if we’re not compensated for that additional risk we’re taking.
Joel: So, how do investors use the earnings yield?
Kyle: So, as investors, again what we care most about is being compensated for that risk we’re taking. But it all comes back to balance. We want to know that we’ve got an appropriately balanced portfolio, that the asset allocation of our overall portfolio is appropriate.
And it’s that tool, the earnings yield – and especially the earnings yield compared to the yield you can get on other investments – that ultimately tells us what the appropriate allocation is.
Valuing Investments: Price-Earnings Ratio, a Money Talk Video with Dave Sandstrom
Earnings, interest rates and valuations, a Money Talk Video with Brian Kilb
Stock valuations: Time to buy or sell? a Money Talk Video with Dave Sandstrom
(initially posted October 3, 2017)