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Earnings Yield- What it tells about Valuation

Akramul AlamPosted by

The Earnings Yield: What does it mean to us?

Earnings Yield is the earnings per share of the company for the last twelve months divided by the current market price per share. Usually, it gives the percentage of how much a company has earned per share or the per-share earnings from each dollar invested in the stock.

Earnings yield provides the same information as a P/E ratio but in a different way. Despite this, the latter is more commonly in use. The earning yield primarily focuses on the rate of return on investment. For investors, however, knowing whether or not their investment value will grow over time is more important. Due to this, investors prefer PE, which is a value-based investment metric, when analyzing stocks.

Formula

Earnings Yield Formula

When calculating the Earnings Yield ratio for a whole index, market price per share is replaced by Market Capitalization of all the listed securities and the EPS is replaced by aggregate earnings of all the listed securities over the same time horizon.

What does Earnings Yield say about Value Investing Strategy?

Though the earnings yield can tell if a stock is under or overvalued, it fails to give a clear picture of the quality of earnings. Further, it does not give a clear understanding of the underlying economics of the business. However, when we use it along with other ratios, it can give useful information.

Many portfolio managers, who select stocks on the basis of valuation, interpret the stocks as “equity bonds.” Stocks do not give you the fixed return like the bonds, rather gives a variable return on the basis of the company’s underlying profit. This way it becomes easier to value a business. And, one of the most common methods of valuing the business is to calculate the earnings yield.

As per famous investor Benjamin Graham, investors should not look to invest in a stock with a higher P/E ratio. Instead, they should look for the sum of the earnings yield and growth rate. Simply put, Graham suggests that investors would be safe if they have a well-diversified portfolio and never pay more than the following formula:

P/E Ratio < Earnings Yield + Growth Rate

This approach closely resembles Peter Lynch’s PEG ratio for value investing. Lynch was one of the most successful mutual fund managers but was very conservative in selecting the stocks. Lynch gave more preference to the stocks with earnings growth less than the PE ratio. Although the majority of stocks would be rejected for value investing through this method, the downside would be minimal and the investor would not be exposed to high risk.

How does the Earnings Yield look like for Dhaka Stock Exchange?

Earnings Yield of DSE Bourse

Between FY2007 and FY2020, the Earnings Yield ratio of the Dhaka Stock Exchange plots a somewhat true reflection of the trade-off between investment returns and business cycle over a 14 years’ timeline that includes a bubble and a bust!

Particulars201220132014201520162017201820192020
DSEX Return-19.8%2.9%12.0%-4.8%8.8%24.0%-13.8%-17.3%21.3%
Earnings Yield8.3%6.6%5.6%6.6%7.0%5.8%6.6%8.7%6.1%
T-bill rate11.0%9.9%8.1%4.2%3.8%4.4%3.6%8.0%2.1%
Excess Return-2.8%-3.2%-2.5%2.4%3.2%1.4%3.0%0.8%4.0%

The chart above shows that a peak in FY2010 is suggested where the Earnings Yield ratio stood the lowest (3.7% yield) suggesting a red signal for the investors. And finally, in 2010-11, the bubble went bust! Surprisingly when the ratio went 8% or more, the market started to rise again as the investors booked a hefty positive excess-return over 364 days treasury bill rate. The long-term 14-year average of Earnings Yield for DSEX stands at 6.1%, which can be used to evaluate the market valuation in conjunction of the opportunity cost scenario i.e., risk-free rate (T-bill rate). From FY2012 to 2020, mostly a higher than average (6.1%) except for 2014 and 2017, was triggered by demand for stocks; it indicates that the market was broadly undervalued during most of that period.

The 2020 Earnings Yield ratio stood at 14 years average level, suggesting a good time for value investors to generate portfolio alpha! In the coming days, the fast-growing economy of Bangladesh is likely to see a bullish cycle, which eventually opens opportunities to investors despite the ongoing crisis of coronavirus (COVID 19) impacts on the global markets. The risk however is subject to the timing and ability to control the outbreak.

Histogram of Earnings Yield (FY2007-14)

– The histogram of Earnings Yield better illustrates the usual level of the metric.

– From 2007 to 2020, in most cases, the metric stood at 7.1% (most frequency level).

– The latest 2020 Earnings Yield stands at 6.1%, suggesting that the market is undervalued when compared with both the long-term average (6.1%) and the most frequency (7.1%) levels.

 

Note: Horizontal axis denotes Earnings Yield level.

Benchmarking the Earnings Yield to find the Fair Value of DSEX

The most frequency level has been considered as the benchmark of the Earnings Yield of DSEX according to the histogram method which accounts for 7.1%. The Earnings Yield of FY2020 accounts for only 6.1% which eventually tells about the potentiality of the investor’s return ultimately.

The following table illustrates the benchmarking:

Understanding the Benchmark Earnings Yield

Current Earnings Yield (FY2020) 6.1%
Earnings Yield at Most Frequency Level (Benchmark) 7.1%

Source: Research and Innovation Lab, Royal Capital Limited

The Benchmark Earnings Yield of DSE comes from the maximum frequency as per the histogram.

The drawbacks of Earnings Yield

Few drawbacks are available on the use of Earnings Yield ratio that investors should be aware of:

  • Earnings yield does not always show the true picture of cash available to the investor. This is because; the companies usually reinvest earnings rather than paying dividends to the shareholders. While the dividend yield is dependent on the management decision of capital allocation, earnings yield does not have any such dependability.
  • If you are using earnings yield as a metric, then it is important to consider the growth prospects of the company as well. Usually, stocks with high growth potential command a higher valuation and may have low earnings yield even when the stock price is on the rise.
  • The earnings yield suffers from the same shortcomings as PE. A company may have a high earnings yield because of a poor outlook as well. Also, a company can manipulate earnings in the short term.
  • It does not talk much about the quality of earnings.
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