Yield-Based Valuation Models

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Yield-Based Valuation Models

In addition to ratio-based measures, you can also use yield-based measures to value stocks. For example, if we invert the P/E and divide a firm’s earnings per share by its market price, we get an earnings yield. If a stock sells for $40 per share and has $2 per share in earnings, then it has a P/E of 20 (40/2) but an earnings yield of 5% (2/40). Unlike P/Es, the nice thing about yields is that we can compare them with alternative investments, such as bonds, to see what kind of a return we can expect from each investment. One main difference, however, is that earnings generally grow over time, whereas bond payments are fixed.

Some context will help you understand

Let’s put earnings yield into perspective. Imagine you could get a risk-free return from Uncle Sam of about 1.75% by buying a 10-year Treasury bond. Therefore, you would want to demand a higher rate of return from your stocks because they are riskier than Treasuries. A stock with a P/E of 25 would have an earnings yield of 4%, which is better than that of Treasuries, but perhaps not enough considering the additional risk you are taking. It all depends on whether the company will be able to grow its profits in the future to make accepting a 4% yield today worthwhile.

Meanwhile, a stock with a P/E of 12 would have an earnings yield of 8.3% (1/12), which is much better than those poky Treasuries, even if earnings never grow. Thus, in this situation you might be induced to take on the additional risk of owning the stock.