A Better Way to Calculate Earnings Yield

Value Stock Investing - A Better Way to Calculate Earnings Yield
By Lee Franzen Lee Franzen


Value stock investing is a favorite method used by many long term investors to generate profits that regularly beat the stock markets annual returns. Value investors generally look for stocks that are currently out of favor with Wall Street, but also have an underlying value that should make them worth more in the future. Put another way, value stocks are currently relatively cheap - you may even want to call them temporarily on sale.

One of the primary screens that can be used in value stock investing to find candidates to buy is earnings yield (EY). This screen is available on some of the free money research sites. On the surface, EY is a simple concept - take a company's net earnings per share (EPS), divide that EPS by the price per share, multiply by 100%, and you have a percentage that equates to what the stock would yield if it distributed all of it's earnings. If you cannot find this indicator on your favorite stock screening web site, just take the P/E ratio (which is contained on nearly all of those screening web sites), and invert it - or multiply it by 1/x. Obviously, the higher the number, the cheaper the stock is relative to it's earnings.

Another way that you should consider calculating earnings yield is more complicated, but will give you a much better view of the way a company is valued relative to it's earnings. This alternate form of the EY calculation was discussed by Joel Greenblatt in his book, "The Little Book That Beats the Market". The alternative EY that he wrote about is useful in comparing stocks that have different tax rates and different levels of debt. Greenblatt's alternative formula is:

EY = pre-tax operating profit (EBIT) / Enterprise Value

First, the numerator in this value stock investing equation (EBIT) is derived from the company's income statement, and the equations denominator (Enterprise Value) is determined by adding the value of all common and preferred equity (number of shares outstanding multiplied by price per share) to the value of all interest bearing debt that the company owes. Interest bearing debt is located on the company's balance sheet.

This alternative way of calculating earnings yield is better than the much more popular E/P method highlighted at the beginning of this article, since it gives a more accurate view of what is happening with cash flows inside of a company, and also gives a more balanced view when comparing multiple companies to each other. Think about it - if a company is using debt to finance it's growth, and you are comparing it to a company with little or no debt, this method of calculating earnings yield clarifies which company is yielding better earnings relative to it's overall financial structure, and is clearly superior for value stock investing.


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