Monevator's financial glossary attempts to explain terms like earnings yield

The earnings yield is a way of looking at the income generated by a company in a similar way to the yield you’d get from a bond or the dividend yield of a share.

It tells you what percentage return the company is making, on the basis of its after-tax income and the price you pay for it.

For example consider a fictional company, Monevator Industries, generating £5 million in net profits, and with a market capitalisation of £100 million.

Earnings yield = Net profit / market capitalisation = 5 / 100 = 5%

That’s it. Simple!

Earnings yield and the P/E ratio

Now you may be thinking at this point about the P/E ratio, in which case stick a gold star on your Investing 101 wall chart and have an extra dollop of ice cream (/glug of Chardonnay) after dinner. You’ve earned it.

The earnings yield is simply the inverse of the P/E ratio.

Forgotten what the P/E ratio is?

P/E = Market Cap / Earnings

For Monevator Industries:

P/E = Market Cap / Earnings = 100 / 5 = 20

Knowing that the earnings yield is the inverse of the P/E ratio makes it a doddle to calculate.

If you know the P/E ratio of a particular company – and you probably do, since P/Es are much more widely quoted than earnings yields – then:

Earnings yield = 1 / the P/E ratio

So for Monevator industries:

Earnings yield = 1 / P/E ratio = 1 / 20 = 5%

As with P/E ratios, you can also calculate the earnings yield on the basis of earnings per share and the share price, instead of net profits and market capitalisation.

For example, as I write SuperGroup is trading at 488p, and is forecast to earn 46.1p in its current financial year.

Earnings yield = 46.1 / 488 = 9.4%

Alternatively, I can see from my data supplier that the P/E of SuperGroup is 10.8.

So:

Earnings yield = 1/10.8 = 9.3%

The two numbers are slightly different, most likely reflecting slightly different analysts’ earnings predictions for earnings being used in the calculation. But they’re close enough.

This brings up an important point…

Earnings yields are not guaranteed returns

If you’re comparing the earnings yield of a share with the yield from a bond, you must remember that profit forecasts for companies are just that – forecasts.

A bond will pay you a fixed and known annual income until it matures (barring defaults).

In contrast, companies can and do lurch from expected profits into losses – or from a predicted loss or small profit into a large profit, or from a bumper profit into a teeny profit, or any other combination.

In short, the return is not guaranteed.

Of course you can use historical data – last year’s earnings – to see precisely what the earnings yield was on a historical basis. However this doesn’t get away from the uncertainty of future earnings, and those are what really matter to you as an investor, unless you’re Dr Who and you fancy using your time machine to invest in the past.

This is one reason why shares have tended to have higher earnings yields than the yield on bonds. The risk and uncertainty of shares must be compensated for by a potentially higher return.

Remember that bonds face their own risks, not least from inflation. Over time, companies have the capacity to raise their prices and profits to keep up with inflation. The income from bonds is fixed, so higher than expected than inflation can result in lower than anticipated real returns from a bond.

The ability to grow earnings over time is also the reason why fast-expanding growth companies can sport low earnings yields, and so at first glance look like terrible investments.

As I write, microprocessor designer ARM Holdings has an earnings yield of 2.5%, which looks like rotten value compared to even 3% from cash stuck in a savings account.

But ARM has grown its net income by around 30% a year on a compound basis over the past five years.

Investors buying ARM shares today on its low earnings yield are betting it will continue its heady rate of growth for years to come, and so make today’s seemingly expensive valuation look like a steal.

Earnings yield versus dividend yield

Small though a 2.5% earnings yield may be, it’s still a lot higher than the 0.7% dividend yield that ARM shares are forecast to pay as an annual dividend.

As for the aforementioned SuperGroup, it has no plans to pay any dividend at all. This means you’ll get no cash whatsoever paid back to you if you buy SuperGroup shares.

I said SuperGroup currently has an earnings yield of 9.4%. So where did that 9.4% go, and have the authorities been informed?

Fear not – this isn’t another example of corporate larceny.

The earnings yield reflects the profits your company has made on your behalf, as a shareholder. The management you employ at your company (it’s nice to have delusions of grandeur) decide every year about how much of those profits to pay out as a dividend, how much to reinvest in growing your business, and how much to spend lining their own pockets.

Another popular alternative for management is to use a portion of the profits to buy back shares in the company, which has the affect of reducing the shares in issuance and so increasing the future earnings per share.1

Some grizzly investors say that the only yield you should care about is the dividend yield. After all, you can’t spend the earnings yield on fast cars and fancy wine – nor reinvest it in other companies for that matter – since it’s not cash in hand. And you can’t be sure that management will wisely grow the business when they reinvest profits. They may very spend too much to acquire a rival, or pay too much to buy back their own shares.

But always remember that as a shareholder you’re a part owner in the business. If your company can successfully expand by reinvesting profits and so deliver sustainably higher earnings in the future then you’ll benefit, either through a higher share price or through a bigger dividend payout.

Other snags with using earnings yield

As a  business owner, you’ll naturally want to know how your company operates in some detail. The earnings yield is just one statistic. It doesn’t tell you much about the company in isolation.

For example, like the P/E ratio it doesn’t take into account how much debt a company is carrying.

To get around these drawbacks, famed US investor Joel Greenblatt suggested in The Little Book That Still Beats the Market that investors use operating profits and enterprise value (instead of net profits and market cap) to calculate the earnings yield. Greenblatt fans have expanded on their rationale for doing so in detail elsewhere on the Web.

Earnings yield long-term gains

Warren Buffett’s company Berkshire Hathaway has only paid a dividend once in 30-odd years. Yet its shareholders have still been well-rewarded, thanks to its remarkable compounded earnings.

Buffett has remorselessly grown Berkshire by reinvesting all its profits. As a result, a single Berkshire Hathaway share that cost $6,000 in 1990 would now set you back over $127,000!

Personally, I like to strike a balance between expectations of future earnings growth and a reasonable dividend payout in hand when I buy shares. After all, there aren’t many Warren Buffetts around to run companies.

The bottom line is there are no one-size fits all rules, so make sure you consider every aspect of a company’s business if you’re working out its earnings yield in order to assess it as a potential investment.

  1. Whether this is a good idea or not compared to paying a dividend is a topic for another day.

Further reading:

  1. Historical versus forecast dividend yield
  2. How to calculate the dividend yield
  3. How to choose a good high yield share for the long haul: HYP Part 2


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