Two friends caught up for a movie at a multiplex. They had lots to discuss as they came out after watching the movie.
Ram: I really liked the scene where the world was turned upside down and Topsy sung ’when you change the view from where you stood, the things you view will change for good.’ It reminded me of looking at the PE ratio upside down as some analysts do these days, although I don’t fully understand it.
Veena: Hey, that’s the earnings yield. It is 1/PE expressed as a percentage. For example, if the PE of a stock is 25 times, then it means its earnings yield is 1/25 = 4 per cent.
Ram: OK, I now get it! Why is it being used?
Veena: Expressing equity valuations in terms of earnings yield makes it easy to compare it as an asset class versus other alternatives you have such as real estate, bonds etc.
Ram: How? I don’t understand?
Veena: Well, when you want to buy a bond you look at bond yields, when you want to buy a real estate property for investment you look at rental yields, so similarly when you are looking at buying equities you must look at earnings yield to see how much your equity investment is going to yield. Amongst other factors, this will help you in understanding whether or not you are over paying for a stock based on fundamental valuation. Ultimately the valuation of any asset has to be based on what income it can generate, and evaluating it based on yields helps.
Ram: OK, so does it mean if the earnings yield is lower than bond yields then one must be cautious?
Veena: It depends. For example, growth stocks may have a low earnings yield as investors expect their earnings to be much higher in future years. However if an equity investment is yielding lower than risk-free government bonds – say the 10 year bond, you must be clear why you are buying a company stock which is yielding lower and be convinced about its growth prospects.
For example, in India, the 10-year government bond has a yield of around 6.2 per cent, while the benchmark Nifty 50 index based on its current price and expected earnings for FY21 has a lower earnings yield of around 4 per cent. On the other hand, in many developed countries such as the US, the UK and Japan, the earnings yield for benchmark index is higher than the government bond yield!
Ram: Interesting. Never realised…
Veena: By the way, there is one more interesting thing here. Investors usually look at the ROE (return on equity) as a metric when they buy shares, but fail to realise that looking at the ROE without considering the P/B (price/book value) may be misleading sometimes. ROE is earnings/book value; so if the ROE is high, but at the same time, the P/B is also high, it means the stock has already priced in the high returns on the book value. So..
Ram: I get it now! So, earnings yield helps cut through this by knocking off the book value component. That is ROE/(P/B) = earnings yield?
Veena: Bingo!