Earnings Yield Ratio (inverse of P/E ratio) is used to measure how many dollars are being earned for each one dollar of stock’s price. In order words, it shows the percentage of total earnings per share against invested amount per share.It tells how expensive the company is in terms of earnings.
Earnings Yield Ratio = [Earnings per share / Stock Price] * 100
Where last twelve month earnings will be taken.
A company Z is a listed company has 1 million registered shares with a current market stock price of $9 per share. Its yearly financial statements have been published, in which net income is of $250,000. As an investor, how do you calculate the yield of your investment in the company?
Earnings per share = $250,000 / $1,000,000 = $0.25
Earning Yield Ratio = [$0.25/$9]*100 = $0.028*100 = 2.8%
The answer can interpret as 0.028 dollar isbeing earned against each $1 invested or earning yield is2.8% of invested amount per share.
Why is the ratio important?
Earnings Yield Ratio helps to compare different stocks with respect to the level of risk. For example, if a risky share has the earning yield of 2% whereas less risk share carries the yield of 4% then you will prefer to invest in the second option.
It is used to check whether the share is undervalued or overvalued by comparing the treasury yield with earning yield of a particular share. For example, if US treasury bills pay an annual return of 12% whereas the company in which you have been invested yields 8% then you can choose the best option for wealth maximization.
Price-Earnings (P/E) Ratio vs.Earning Yield Ratio
P/E ratio measures how many dollars are being paid for each one dollar of earnings whereas the earning yield (being the inverse of P/E ratio) describes how many dollars are being earned against each dollar of price per share or invested amount per share.