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| Earnings
Yields |
What It Is:
The earnings yield is the ratio of a company�s last twelve months (LTM) of
earnings per share to its stock price. It is the inverse of the P/E ratio.
The formula for earnings yield is:
LTM EPS/ Stock Price = Earnings Yield
How It Works/Example:
Let�s assume XYZ Company�s last twelve months of earnings total $0.75 per
share. If XYZ stock is currently trading at $10.00, then using the formula
above, we can calculate that XYZ Company�s earnings yield is:
$0.75/$10.00 = 7.5%
Why It Matters:
The earnings yield is a way to measure returns, and it helps investors evaluate
whether those returns commensurate with an investment�s risk. For example, the
investor may not feel that 7.5% adequately compensates for the added risk of
owning XYZ Company stock if lower-risk stocks carry yields of 8.5%. However, a
7.5% earnings yield could be attractive if similar companies yield only 5%.
It is important to note that earnings yield does not always represent cash
available to the investor, because companies may choose to reinvest earnings
rather than pay dividends to shareholders. Unlike the dividend yield, earnings
yield is not dependent on management�s capital-allocation decisions.
Earnings yield is a critical component of the Fed Model, which evaluates whether
stocks are overvalued or undervalued. However, it is only one method for
evaluating investments; it is no substitute for comprehensive analysis. Even
though earnings and stock prices are somewhat correlated, the price at which the
investor buys and then sells a stock ultimately determines returns.
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