The earnings yield (aka earnings-price ratio, E/P ratio) for stocks is the inverse of the price-earnings ratio (P/E) of stocks, and is equal to the earnings per share of common stock divided by the market price of the stock. The E/P ratio increases with earnings and decreases with increases in the stock price.
Earnings Yield = Earnings per Share of Common Stock / Stock Price
Traders sometimes compare the earnings yield of stocks to bonds, money market instruments, or Treasuries. One rule of thumb, based on how closely the earnings yield of the S&P 500 stocks and the yield on 10-year Treasury bonds have tracked each other over the past few decades, is that if the earnings yields on stocks is less than 10-year Treasuries, then the stock market as a whole is overvalued, since higher stock prices will lower the earnings yield. For instance, in June, 2007, the 10-year Treasury note yielded 4.95%, while stocks in the S&P 500 averaged 4.19%, thus indicating that stocks were overvalued, especially considering that Treasuries have much lower risk. Subsequently, stocks declined dramatically over the next year and a half. In March, 2009, the 10-year Treasury yielded 2.89% while the S&P yielded 9.51%. Over the next 5 years, the S&P 500 index more than doubled!
Example—Calculating the Earnings Yield from the P/E ratio of a stock.
If a stock has a P/E ratio of 20, then what is its earnings yield?
Earnings Yield = 1 / P/E = 1 / 20 = 0.05 = 5%
Earnings Yield and Return on Equity
The earnings yield is also related to the return on equity (ROE), which is simply the earnings per book value, and can be found by multiplying the earnings yield (E/P) by the price/book value (P/B).
ROE = Earnings / Book Value
Note that the stock price in both numerator and denominator of the 2nd equation cancel each other, equaling the right-hand side of the 1st equation, thereby proving that the 2 equations are equal. Solving for E/P in the 2nd equation by dividing both sides by P/B yields:
|E = Earnings|
P = Stock Price
B = Book Value