The earnings yield formula
Earnings yield = earnings per share ÷ share price = 1 ÷ (P/E ratio)
Northfield Tools, the fictional industrial company in these guides, earned $2.88 a share on a diluted basis and trades at $60, so its earnings yield is 2.88 ÷ 60 = 4.8%, the inverse of its 20.8× P/E. Every choice that affects the P/E affects the yield in the same way: trailing or forward earnings, GAAP or adjusted, basic or diluted. Use diluted earnings and say which period you used; the forward vs trailing P/E article covers the difference, and what is a good P/E ratio covers what the multiple itself should be.
Two things make the yield more useful than the multiple it inverts. It can be averaged: a company earning $2.00, $3.00 and $4.00 over three years has a three-year average earnings yield that means something, while the average of three P/E ratios does not. And it handles tiny earnings gracefully: a company earning a cent a share has a P/E in the thousands and an earnings yield near zero, which is the honest description. The yield is also the form in which valuation enters the arithmetic of returns, because a return is a yield plus growth plus any change in the multiple, and only the first two can be estimated from the business itself.
The enterprise value version: EBIT ÷ EV
Firm earnings yield = operating income (EBIT) ÷ enterprise value
The per-share yield is after interest and tax, so it depends on how the company is financed and where it pays tax. Dividing operating income by enterprise value instead compares the profit of the whole business with the price of the whole business, which makes companies with different debt levels comparable. Northfield's enterprise value is its $3,000 million market capitalisation plus $300 million of net debt including leases, or $3,300 million, and its operating income is $210 million, so its firm earnings yield is 210 ÷ 3,300 = 6.4%. The figure is higher than 4.8% because it is before tax and because it is measured against a larger denominator that includes the debt. It is the yield used in the "magic formula" style of screen that ranks companies on earnings yield and return on capital together, and the enterprise value vs market cap article explains the denominator.
Comparing an earnings yield with a bond yield
The reason to express earnings as a yield is to compare them with the alternative. If a ten-year government bond yields 4% and Northfield's earnings yield is 4.8%, the stock offers less than a point of extra current yield for considerably more risk. That sounds unattractive until the differences are counted:
| Government bond | Northfield shares | |
|---|---|---|
| Current yield | 4.0%, paid in cash | 4.8%, mostly retained and reinvested |
| Growth of the payment | None | Earnings expected to grow |
| Inflation | Erodes the fixed coupon | Earnings tend to rise with prices |
| Certainty | Near certain | None; earnings can fall |
A fairer comparison adds expected growth to the earnings yield: 4.8% plus, say, 6% growth suggests something near 10% a year if the multiple holds, against 4% certain. Whether six points of extra return is enough for the risk is the investor's judgment, and it is the same judgment the WACC formula article turns into a discount rate. The so-called Fed model, which says stocks are fairly priced when the market's earnings yield equals the bond yield, ignores both growth and inflation and has a poor record; the comparison is useful as a frame, not as a rule.
Three yields, one question
Earnings yield, free cash flow yield and dividend yield each ask what the price buys, with a different numerator. For Harbor Foods, the fictional packaged-food company used elsewhere in these guides, net income of $120 million on a $1,500 million market value is an 8.0% earnings yield, free cash flow of $100 million is a 6.7% free cash flow yield, and dividends of $45 million are a 3.0% dividend yield. They should roughly agree, and the gaps are informative: earnings above cash flow means profit is not all converting to cash; cash flow far above dividends means most of the cash is retained or used for buybacks. When the earnings yield is much higher than the cash flow yield for several years, the earnings are the suspect.
Traps
- Peak earnings. A cyclical company at the top of its cycle shows a high earnings yield exactly when earnings are about to fall. Average several years, or use the firm version on mid-cycle operating income.
- One-offs. A disposal gain lifts earnings and the yield for a year. Normalise first.
- Adjusted earnings. Yields built on earnings that exclude stock-based pay and amortisation overstate the return to shareholders. Use GAAP or state the basis.
- Negative earnings. The yield is negative and the comparison with a bond meaningless; use revenue multiples, cash burn and the path to profit instead.
- Mixing denominators. Net income over enterprise value, or operating income over market capitalisation, mixes equity and firm figures and produces a number that belongs to neither.
- Currency and listing. For a company reporting in one currency and quoted in another, convert earnings at the same rate as the price before dividing, or the yield is wrong by the exchange-rate move.
The stock valuation guide places earnings yield among the methods that do the heavier work, and for the question it was built to answer, what the price is asking the business to deliver, The Bar translates a share price into the earnings and growth a company needs and sets them against the consensus.
See the earnings a price requires
The Bar translates a share price into the earnings and growth a company must deliver, and sets them against what analysts expect.
Frequently asked questions
What is a good earnings yield?
One that, together with expected growth, offers a return comfortably above a safe bond yield for the risk taken. With government bonds near 4%, an earnings yield of 5% to 7% on a stable, growing business is a reasonable range; a much higher yield usually means earnings are at a cyclical peak or expected to fall, and a lower one requires strong growth to justify. Judge it with the growth and the quality of the earnings.
How do you calculate earnings yield?
Divide earnings per share by the share price, or equivalently divide 1 by the P/E ratio. A stock earning $2.88 a share at $60 has a 4.8% earnings yield and a P/E of 20.8. Use diluted, GAAP earnings and say whether the period is the last twelve months or a forecast. For comparing companies with different debt levels, divide operating income by enterprise value instead.
What is the difference between earnings yield and dividend yield?
Earnings yield measures all the profit the company earns per dollar of share price, whether paid out or retained; dividend yield measures only the part paid out in cash. A company with an 8% earnings yield and a 3% dividend yield retains most of its profit for reinvestment, buybacks or debt reduction. Earnings yield is the broader measure; dividend yield the cash in hand.
Should earnings yield be higher than the bond yield?
Usually, because shares carry more risk than government bonds, but the gap is not fixed and should not be read as a rule. Equities offer earnings that can grow and tend to keep pace with inflation, which a bond coupon does not, so a modest gap can be reasonable when growth is strong and a wide gap can be inadequate when earnings are about to fall. Compare yield plus expected growth with the bond, not yield alone.
What is EBIT to enterprise value?
Operating income divided by enterprise value: the earnings yield of the whole business rather than of the shares. It removes the effects of debt and tax, so companies with different capital structures can be compared, and it is the yield used in screens that rank companies on earnings yield and return on capital together. It is before tax, so it reads higher than the per-share earnings yield for the same company.