One way to think about what you're paying for a company is to look at its price-to-earnings, or P/E, ratio. Another way is to calculate the inverse of that, which is its earnings yield.
Consider the mythical example of Fryyndar and Ulf Scandinavian Pharmaceuticals (ticker: FANDU), whose motto is "Varsagod och svalj!" (That's Swedish for "Here, swallow this pill!") To calculate its P/E ratio, 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 ratio, dividing the annual EPS by the current stock price. Divide $3 by $111 to get 0.027, or 2.7%. Compared with 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 by 10% per year. If so, in 10 years, EPS should grow to by $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 the growing earnings yield to pass the current 30-year bond rate, which is now nearly 5%. FANDU passes it within six years. (You can also compare it with shorter-duration bonds, and you can look up current bond rates on Yahoo!)
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 make sense of financial statements in our "Crack the Code: Read Financial Statements Like a Pro" how-to guide (also known as an online seminar). Give any of our how-to guides a whirl. More than 90% of those who've taken them have consistently given them high marks -- and besides, we offer a satisfaction guarantee, or you get your money back.
By the way, if you'd like to receive several promising stock ideas by email each month, learn more about our suite of investment newsletters, which we offer along with some free research reports. The newsletters' performance may surprise you. You can also learn all about brokerages and find one that's right for you by going to our Broker Center.