Evaluating Earnings Yield (EY) as a measure of valuation

Most of you must have heard of the dividend yield. It is the dividend per share dividend by the market price of the share. Normally, companies with higher dividend yields are considered to be underpriced while stocks with lower dividend yield are considered to be overpriced. If you substitute the DPS with the EPS, you will get the earnings yield. The earnings yield is, therefore, nothing but the EPS/Price per share. Alternatively, it can also be written as the Net profit of the company / market capitalization of the company.
Like in case of dividend yield, in case of Earnings Yield also a lower value is a sign of overpricing and a higher value is a sign of under-pricing. What does the earnings yield indicate? It is an indication of the payback period of your stock. It shows how much of the price you pay for the stock will be earned back by you each year. An earnings yield of 10% means that 10% of your price paid will be earned back each year. Remember, Earnings Yield represents the overall earnings of the company. Out of this net profit, a part of the amount is paid as dividends and the balance is transferred to the reserves of the company. While the dividend yield only captures the tangible yield of the company, the Earnings yield also captures the tangible and intangible yield of the company.

Earnings yield versus dividend yield..
The ratio of the dividend yield to your earnings yield shows how much of your earnings are directly distributed. A high ratio of DY to EY indicates that the company is distributing a greater chunk of its profits to the shareholders. This is normal in case of utilities and companies in matured sectors where there is no great scope for expansion of markets or for making acquisitions. In such cases, the company may choose to reward the shareholders through higher dividend yields. A lower ratio of DY to EY is more common among companies that are in the growth stage and will be depending on internal resources to finance their expansion and diversification. That has been the case with IT companies where the earnings run into billions of dollars but the dividend yields are quite low. This is not only unique to India but is the case with IT companies abroad too. In case your ratio of DY to EY is low then you need to be clear that the company needs to earn a much higher ROE to compensate for the lower dividend payouts.

Earnings yield versus bond yields..
This is a common metrics used across markets. The argument is that since earnings yield represents the yield on equity and bond yields represent the yield on debt, there should be a comparison of yields possible. The bond yield is nothing but the annual interest payable on the bond divided by the price of the bond. It shows how much you will effectively earn if you buy into the bond today. Analysts go a step further. They compare the earnings yield with the bond yields and take a view on which asset class is more attractive. So if bond yields are higher than earnings yields then it means that bonds are more attractive than equities and vice versa. But there are problems in the argument!
Firstly, both the earnings yield and the bond yields are based on historical data while an investment call is based on future expectations. Secondly, in the current global scenario, the interest rates are low due to conscious central bank policy. That has kept yields low too. As a result the earnings yield may be relatively more attractive than the bond yields. But that could be a misleading argument because equities can grossly underperform debt if the yields start going up from here. Also the bond yields only consider the interest component and not the capital appreciation component, which is the key in bond valuations.

Earnings yield is nothing but the inverse of the P/E ratio..
One of the reasons why the Earnings yield has not become too popular is that it is nothing but the inverse of the P/E ratio. Thus a company with a P/E ratio of 12.5X will logically have an earnings yield of 8% (100/12.5). Since the concept of earnings yield is already captured indirectly in the P/E ratio, most analysts do not see too much merit in focusing on Earnings yield as a unique measure of value. Having said that, it is essential to remember that earnings yield is a good concept to understand and at a macro level it does offer a good metrics to compare yields across asset classes!