Another Stock Evaluation Tool

One way to evaluate the fair price of a company is to look at its price-to-earnings ratio (P/E). Another way is to calculate the inverse of that, which is its earnings yield.

Consider the example of Fryyndar and Ulf Scandinavian Pharmaceuticals (ticker: FANDU), whose motto is "Varsågod och svälj!" (That's Swedish for "Here, swallow this pill!") To calculate its P/E, you simply divide the current stock price by the annual earnings per share (EPS). If its current annual EPS is $3 and the stock is trading for $111 per share, the P/E is $111 divided by $3, or 37.

To calculate Fryyndar and Ulf's earnings yield, just reverse the P/E, dividing the annual EPS by the current stock price: $3 divided by $111 equals 0.027, or 2.7%. Compared to risk-free Treasury bond rates (of roughly 5% at the time of this writing), this doesn't appear to be a bargain. But remember: Whereas bond rates are usually fixed, earnings typically grow. Imagine that FANDU is expected to increase earnings 10% per year. If so, in 10 years the company's EPS should grow to $7.78. Assuming we bought shares when they were at $111, the earnings yield for us has now become 7%, considerably better ($7.78 divided by $111 is 0.07).

It can be instructive to see how long it takes for the growing earnings yield to pass the current 30-year bond rate. FANDU passes it within six years. You can also compare it with shorter-duration bonds, which you can look up on Yahoo! (Nasdaq: YHOO  ) .

If your desired rate of return on your invested dollars is 15%, it will take FANDU 18 years to reach that target -- if earnings actually grow at the estimated pace, that is. Perhaps you can find another investment that will get you there more quickly. With riskier companies, you might look for them to pass your target rate sooner rather than later.

The earnings yield is just one of many investor tools. It shouldn't dictate any decision for you, but it can help you think more effectively about your expectations for investments.

To learn more about how to decipher financial statements and evaluate companies, visit ourFool's School. Or check out our well-regardedhow-to guides and online seminars.

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