It would be nice if looking at price, P/E, and earnings yield was all there is to it. Find an earnings yield of 6% (PE of 17), beat the bond, and move on.
But you're buying equities, not bonds, right?
- Because you want to participate in company growth and success.
- Because, simply, you want to leave that static bond yield in the dust - if not today, sometime in the near future.
- And you want to keep up with - or better yet, beat - inflation.
- So to do that, you assume some risk that earnings won't happen, but you are hanging your hat on growth and a stock price that keeps up with it.
- Buy a bond for $100; receive $5 per year for 10, 20, 30 years; never look back.
or
- Buy a stock for $100, earnings per share constant at $5 for 10, 20, or 30 years with no change.
Less risk.
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But suppose the $5 earnings "coupon" grows at 10% per year. What happens at the end of year 10?
If the price were to stay the same, your $100 investment would be returning $12.97 in year 10, which is almost 13% earnings yield, or an implied PE of 7.7 at today's price.
A pretty nice yield, which really means the price of your investment should go up, because it's worth more.
This spreadsheet shows future earnings yields realized in the case of a bond with no growth versus a stock with a 10% earnings growth.
http://spreadsheets.google.com/ccc?key=0AuRRzs61sKqRcjdfd19OVTZrVVRlTUJnb05naGo3TWc&hl=en
So you can see that assessing growth is a major factor in analysing a stock price through PE.
Above all else, earnings growth drives stock price growth.
So value investors look closely at what the earnings yield is today and what will it be in the future.
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