Monday, October 30, 2006

Earnings yield

Earnings yield is the reciprocal of the Price Earnings Ratio or P/E Ratio or PER. For those mathematically inclined, well you know what's a reciprocal, as in not "you love someone and someone love you back" that kind lah.

For those who thought that it was "you love someone and someone love you back", umm ok you are wrong and here's the correct formula:

P/E Ratio = Share price / Earnings per share (EPS)
Earnings yield = Earnings per share (EPS) / Share price

or

P/E Ratio = Mkt cap / Net Profit
Earnings yield = Net Profit / Market cap

If you still having problems, try reading a few related posts below.
1) Price Earnings Ratio
2) Market Cap
3) Net Profit

Ok, now that we know what is Earnings Yield, let's try to examine it further. Now if you think about it, Earnings Yield is actually the return that you can get by investing in this stock. Say if a stock has an Earnings Yield of 10%, it means that by investing $100 in the stock, you would get $110 back by the end of the year.

Now if you get this, cheaper P/E means higher return right? Because Earnings Yield of 10% would mean that the P/E of the stock is 10x. (10% = 0.1 and reciprocal of 0.1 = 10.) And P/E of 10x is damn bloody cheap because it means that the stock can give you 10% return p.a. and as we all know (hopefully) investment on average earns you 5-8% over the long run.

Consider NOL, which trades at P/E of 3x, it means that its earnings yield is 33%. Sounds like a screaming buy right? Actually, it is a huge debate right now, nobody knows the answer. This is because no one is sure that the P/E can remain at 3x, say 5 yrs from now. This means that some players in the market think that NOL may lose truckloads of money in the next 5 yrs. And he is not willing to buy it now, even if NOL is super cheap today.

As with intrinsic value and forward PER (i.e. P/E ratio in the future) guesswork is involved here. And the guesswork is the usually the one thing that determines whether you will lose truckloads of money or not. Well investing is not easy, I guess. Earnings yield is just another tool to try to make solving a 10 trillion step equation 1 step easier.

See also What drives stock prices
and Expectations vs Reality
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