The earnings yield (aka earnings-price ratio, E/P ratio) for stocks is the inverse of the price-earnings ratio (P/E) of stocks, and equals earnings per share of common stock divided by the market price of the stock. The E/P ratio increases with earnings and decreases with increases in the stock price.
Earnings Yield = Earnings per Share of Common Stock / Stock Price
Traders sometimes compare the earnings yield of stocks to bonds, money market instruments, or Treasuries. One rule of thumb, based on how closely the earnings yield of the S&P 500 stocks and the yield on 10-year Treasury bonds have tracked each other over the past few decades, is that if the earnings yields on stocks is less than 10-year Treasuries, then the stock market as a whole is overvalued, since higher stock prices will lower the earnings yield. For instance, in June, 2007, the 10-year Treasury note yielded 4.95%, while stocks in the S&P 500 averaged 4.19%, thus indicating that stocks were overvalued, especially considering that Treasuries have much lower risk. Subsequently, stocks declined dramatically over the next year and a half. In March, 2009, the 10-year Treasury yielded 2.89% while the S&P yielded 9.51%. Over the next 5 years, the S&P 500 index more than doubled!
If a stock has a P/E ratio of 20, then what is its earnings yield?
Earnings Yield = 1 / P/E = 1 / 20 = 0.05 = 5%
The earnings yield is also related to the return on equity (ROE), which is simply the earnings per book value, and can be found by multiplying the earnings yield (E/P) by the price/book value (P/B).
ROE = Earnings / Book Value
Return on Equity
ROE = (E / P) * (P / B) = (E / B)
Note that the stock price in both numerator and denominator of the 2nd equation cancel each other, equaling the right-hand side of the 1st equation, thereby proving that the 2 equations are equal. Solving for E/P in the 2nd equation by dividing both sides by P/B yields:
Earnings/Price Ratio
E / P = ROE / P/B
- E = Earnings
- P = Stock Price
- B = Book Value