The price/earnings (P/E) ratio, also known as an āearnings multiple,ā is one of the most popular valuation measures used by investors and analysts. The basic definition of a P/E ratio is stock price divided by earnings per share (EPS). The ratio construction makes the P/E calculation particularly useful for valuation purposes, but itās tough to use intuitively when evaluating potential returns, especially across different instruments. This is where earnings yield comes in.
P/E Ratio
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 stockās P/E to those of other similar-sized companies in its sector, as well as to the sectorās 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 stockās 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.
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/Eās 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, 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 companyās 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.
EPS
EPS is the bottom-line measure of a companyās profitability and itās 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.
Earnings Yield
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 āttmā) 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. Letās 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 Bās P/E of 10 and the junk bondās 6% yield is akin to comparing apples and oranges.
But using Stock Bās 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.