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Position: 2018 Capital Investment Management > 文件區 > Investment strategy
by 趙永祥, 2018-09-28 07:46, Views(611)


Earnings Yield Defined


Earnings yield is defined as EPS divided by the stock price (E/P). In other words, it is the 

reciprocal of the P/E ratio. Thus, Earnings Yield = EPS / Price = 1 / (P/E Ratio), expressed as 

a percentage.

If Stock A is trading at $10 and its EPS for the past year (or trailing 12 months, abbreviated as 

“ttm”) was 50 cents, it has a P/E of 20 (i.e. $10/50 cents) and an earnings yield of 5% 

(50 cents/$10).

If Stock B is trading at $20 and its EPS (ttm) was $2, it has a P/E of 10  (i.e. $20/$2) and an 

earnings yield of 10% ($2/$20).

Assuming that A and B are similar companies operating in the same sector, with nearly 

identical capital structures, which one do you think represents the better value?

The obvious answer is B. From a valuation perspective, it has a much lower P/E. 

From an earnings yield point of view, B has a yield of 10%, which means that every dollar 

invested in the stock would generate EPS of 10 cents. Stock A only has a yield of 5%, which 

means that every dollar invested in it would generate EPS of 5 cents.

The earnings yield makes it easier to compare potential returns between, for example, a stock 

and a bond. Let’s say an investor with a healthy risk appetite is trying to decide between 

Stock B and a junk bond with a 6% yield. Comparing Stock B’s P/E of 10 and the junk bond’s 

6% yield is akin to comparing apples and oranges.

But using Stock B’s 10% earnings yield makes it easier for the investor to compare returns and decide whether the yield differential of 4 percentage points justifies the risk of investing in the stock rather than the bond. Note that even if Stock B only has a 4% dividend yield (more about this later), the investor is more concerned about total potential return than actual return.


EPS and P/E


EPS is the bottom-line measure of a company’s profitability and it's basically defined as 

net income divided by the number of outstanding shares

Basic EPS uses the number of shares outstanding in the denominator while fully diluted EPS 

(FDEPS) uses the number of fully diluted shares in the denominator.

Likewise, P/E comes in two main forms:

  • Trailing P/E. This is the price/earnings ratio based on EPS for the trailing four quarters or 12 months.
  • Forward P/E. This price/earnings ratio is based on future estimated EPS, such as the current fiscal or 
  • calendar year, or the next year.

The P/E ratio for a specific stock, while useful on its own, is of greater utility when compared 

against other parameters, such as:

Sector P/E. Comparing the stock’s P/E to those of other similar-sized companies in its sector, 

as well as to the sector’s average P/E, will enable the investor to determine whether the stock is trading at a premium or discount valuation compared to its peers.

Relative P/E. Comparing the stock's P/E with its P/E range over a period of time provides an 

indication of investor perception. A stock may be trading at a much lower P/E now than it did in the past because investors perceive that its growth has peaked.

P/E to Earnings Growth (PEG Ratio). The PEG ratio compares the P/E to future or past 

earnings growth. A stock with a P/E of 10 and earnings growth of 10% has a PEG ratio of 1, 

while a stock with a P/E of 10 and earnings growth of 20% has a PEG ratio of 0.5. 

According to the PEG ratio, the second stock is undervalued compared to the first stock.

Using Earnings Yield to Compute Dividend Payout Ratio

One issue that often arises with a stock that pays a dividend is its payout ratio, 

which translates into the ratio of dividends paid as a percentage of EPS. 

The payout ratio is an important indicator of dividend sustainability. If a company consistently 

pays out more in dividends than it earns in net income, the dividend may be in jeopardy at some point. While a less-stringent definition of the payout ratio uses dividends paid as a percentage of cash flow per share, we define dividend payout ratio in this section as: dividend per share (DPS) / EPS.

The dividend yield is another measure commonly used to gauge a stock's potential return. 

A stock with a dividend yield of 4% and possible appreciation of 6% has a potential 

total return of 10%.

Dividend Yield = Dividends per Share (DPS) / Price

Since Dividend Payout Ratio = DPS / EPS, dividing both the numerator and denominator by price gives us:

Dividend Payout Ratio = (DPS/P) / (EPS/P) = Dividend Yield / Earnings Yield

Examples

Let’s use Procter & Gamble Co to illustrate this concept. 

P&G closed at $74.05 on May 29, 2018. The stock had a P/E of 19.92, based on trailing 12-month EPS, and a dividend yield (ttm) of 3.94%.

P&G’s dividend payout ratio was therefore = 3.94 / (1/19.92)* = 3.94 / 5.02 = 78.8%

*Remember that Earnings Yield = 1 / (P/E Ratio)

The payout ratio could also be calculated by merely dividing the DPS ($2.87) by the EPS 

($3.66) for the past year. However, in reality this calculation requires one to know the actual 

values for per-share dividends and earnings, which are generally less widely known by 

investors than the dividend yield and P/E of a specific stock.

Thus, if a stock with a dividend yield of 5% is trading at a P/E of 15 

(which means its earnings yield is 6.67%), its payout ratio is approximately 75%.

How does Procter & Gamble’s dividend sustainability compare with that of telecom services 

provider CenturyLink Inc, which had the highest dividend yield of all S&P 500 constituents in 

May 2018, at over 11%? With a closing price of $18.22, it had a dividend yield of 11.68% and 

was trading at a P/E of 8.25 (for an earnings yield of 12.12%). 

With the dividend yield just below the earnings yield, the dividend payout ratio was 96%.

In other words, CenturyLink’s dividend payout may be unsustainable because it was nearly 

equal to its EPS over the past year.  With this in mind, an investor looking for a stock with a 

high degree of dividend sustainability may be better off choosing Procter & Gamble.


P/E Versus Earnings Yield

The P/E’s pre-eminence as a valuation measure is unlikely to be derailed anytime soon by 

the earnings yield, which is not as widely used. While the major advantage of the earnings 

yield is that it enables an intuitive comparison of potential returns to be made, it has the following

drawbacks:

Greater Degree of Uncertainty. 

The return indicated by the earnings yield has a much greater 

degree of uncertainty than the return from a fixed-income instrument.

More Volatility. Since net income and EPS can fluctuate significantly from one year to the 

next, the earnings yield will generally be more volatile than fixed-income yields.

Indicative Return Only. The earnings yield only indicates the approximate return based on 

EPS; the actual return may diverge substantially from the earnings yield, especially for stocks 

that pay no dividends or small dividends.

As an example of the last point, assume a fictitious Widget Co. is trading at $10 and will earn 

$1 in EPS over the year ahead. If it pays out the entire amount as dividends, the company 

would have an indicated dividend yield of 10%. What if the company does not pay any dividends? 

In this case, one avenue of potential return to Widget Co. investors is from the increase in the company’s book value thanks to retained earnings (i.e. it made profits but did not pay them out as dividends).

To keep things simple, assume Widget Co. is trading exactly at book value. 

If its book value per share increases from $10 to $11 (due to the $1 increase in retained 

earnings), the stock would trade at $11 for a 10% return to the investor. 

But what if there is a glut of widgets in the market and Widget Co. begins trading at a big discount to book value? In that case, rather than a 10% return, the investor may incur a loss from the Widget Co. holdings.

The Bottom Line

P/E ratio may be the established standard for valuation purposes, but its reciprocal – 

the earnings yield – is especially useful for comparing potential returns across different 

instruments. The earnings yield also enables back-of the-envelope calculations to be made for 

computing the dividend payout ratio of a stock using widely followed measures such as its dividend yield and P/E ratio.



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