What is Earning Yield?
The profit gauge, aka earnings yield, reveals how much profit each share generates per dollar invested. Simply divide earnings per share (EPS) by the stock price, and you've got it. Think of it as the flip side of the P/E ratio, which tells you how much investors pay for each dollar of profit.
This gauge helps compare returns across stocks, or even against bonds and bills. A high-profit gauge compared to other options might signal an undervalued gem, offering potentially higher returns than safer bets.
How Earning Yield Works
The relative return ratio proves useful for evaluating the payoff potential of different stocks or differentiating them from other investment alternatives, like bonds or treasury bills. If a stock's return-to-risk ratio surpasses the interest rate offered by a bond or a treasury bill, it might appear undervalued, as it suggests a higher return than the safe haven rate. However, it's imperative to remember that this ratio doesn't factor in the company's growth potential, inherent vulnerabilities, or capital makeup. Therefore, solely basing your value assessment on it wouldn't be prudent.
Example: A company with earnings per share (EPS) of ₹16 and a stock price of ₹350. Its return on investment (ROI) translates to 0.046, or roughly 4.6%. This implies that for each rupee invested in this company's stock, you reap 4.6 paise in the form of profit. If the ten-year government bond yield is at 3%, this company's stock might appear underpriced given its higher payoff potential compared to the safe-haven option.
However, if the company's future profit outlook is bleak or if it carries a significant debt burden, its stock might not be a good investment despite the high profit-share ratio. This highlights the importance of using this ratio alongside other valuation metrics like the P/E ratio, the PEG ratio, the dividend yield, and the free cash flow yield for a more comprehensive assessment.
How the Earning Yield Can Help Investors
Investors wield the profit share gauge, or earnings yield, to compare and choose among various investments, from stocks to bonds. It also helps them assess if their own shares are diamonds in the rough or overpriced pebbles, simply by comparing their yield ratio to industry peers.
Think of it as a balancing scale. If a stock's profit share ratio outweighs safe options like bonds, it might be a hidden gem. This higher return potential compared to stable investments suggests potential for growth and strong financials.
But remember, the profit share gauge is just one factor. It doesn't see the future or reveal hidden risks. So, while valuable, it's best used in tandem with other valuation tools for a more accurate picture.