If you've been around the investing block a few times, price-to-earnings (P/E) ratios will seem as common and uninteresting to you as cigarette butts strewn on the street. (Why is it that so many smokers think of our streets and yards as their ashtrays? Do they think that, just because a cigarette butt is small, it's not an eyesore? That, since it will disintegrate in a few years, it doesn't matter?)
But even fairly experienced investors are often not familiar with the second cousin of the P/E ratio: the earnings yield. Lest you fall into the sorry-haven't-heard-of-it camp, permit me to review it today, as it's pretty interesting and perhaps will even prove useful to you in your investing.
First, though, for those who need it, are some links to briefings on the P/E ratio. Here's a quick rundown on what it is, from our Ask the Fool series. And to prevent you from getting too excited about the P/E and putting too much, er... stock... in it, here are part one and part two of a series by Zeke Ashton on why it's not all it's often cracked up to be, and an enlightening article by Rich McCaffery on the same topic.
OK, now back to our new friend, the earnings yield. Recall that the P/E ratio is simply a stock's current price, divided by its earnings per share (EPS). (They're typically earnings from the past 12 months or estimated earnings for the upcoming year.) The earnings yield is simply the inverse of that -- an E/P ratio, essentially. Take the annual EPS and divide it by the current stock price. Let's do just that for a number of high-profile companies:
Company Stock EPS P/E Earnings
price yield Berkshire Hathaway $2405 $111 21.7 4.6%
Coca-Cola 46.55 1.65 28.2 3.5
(NYSE:KO)Costco 34.92 1.54 22.7 4.4
(NASDAQ:COST)Dell Computer 31.72 0.86 36.9 2.7
(NASDAQ:DELL)eBay 96.83 1.00 96.8 1.0
(NASDAQ:EBAY)General Electric 30.43 1.48 20.6 4.9
(NYSE:GE)H&R Block 42.53 2.93 14.5 6.9
(NYSE:HRB)Home Depot 32.42 1.59 20.4 4.9
(NYSE:HD)Johnson & Johnson 52.07 2.26 23.0 4.3
(NYSE:JNJ)Martha Stewart 10.19 0.06 169.8 0.6
(NYSE:MSO)McDonald's 21 0.79 26.68 3.8
(NYSE:MCD)Merck 58.16 3.19 18.2 5.5
(NYSE:MRK)Microsoft 24.16 0.87 27.8 3.6
(NASDAQ:MSFT)Paychex 30.10 0.78 38.6 2.6
(NASDAQ:PAYX)PepsiCo 44.10 1.92 23.0 4.4
(NYSE:PEP)Pfizer 33.35 1.91 17.5 5.7
(NYSE:PFE)Sara Lee 18.61 1.56 11.9 8.4
(NYSE:SLE)Southwest Airlines 16.56 0.30 55.2 1.8
(NYSE:LUV)Starbucks 24.24 0.62 39.1 2.6
(NASDAQ:SBUX)Verizon 39.14 2.30 17.0 5.9
(NYSE:VZ)Wal-Mart 54.54 1.86 29.3 3.4
(NYSE:WMT)Yum! Brands 28.07 1.87 15.0 6.7
(NYSE:YUM)(data above is from 6/10/03)
Well, that was exciting. But what do all these numbers mean? What do the earnings yields tell us? Basically, they can give us a sense of the bang for the buck offered by a given stock at a given price. Some people look to the dividend yield for such a measure, but many companies pay little or nothing in the way of dividends, so the dividend yield doesn't really tell you how productive a company is.
One thing to do with an earnings yield is compare it with risk-free Treasury bond rates, which you can look up in spots such as Yahoo!'s bond rate nook. Ten- and 30-year bonds are yielding between about 3% and 4%, and that's pretty much risk-free (unless you think the U.S. government is exceedingly wobbly). Given that you can earn 3% to 4% risk-free, perhaps think twice about investing in stocks that are essentially yielding (kicking out in earnings) 1% or 2% or even 3% annually. Some companies may be fairly solid, but they're certainly not risk-free.
Think of it this way. If you can get, say, 3% pretty much guaranteed via risk-free bonds, then you should demand considerably more from another investment that carries more risk. You should demand a risk premium in your return. So while you'll accept a 3% return on your bonds, you might accept nothing less than a 7% or 8% return on your stocks.
Of course, the earnings per share for healthy, growing companies aren't usually static. They grow over time. That means that the earnings yield we calculate today on a company's current EPS isn't what we should expect in the years to come.
Consider as an example: Dell Computer and its 2.7% earnings yield. In fiscal 2003, Dell's EPS grew 23% over fiscal 2002 levels, to $0.80. In 2002, they were 23% below 2001. In 2001, they increased 24% over 2000. In 2000, 28% over 1999. In 1999, 64% over 1998. So the picture is generally of 20%-plus EPS growth. Let's be more conservative and expect Dell to only increase EPS by 12% per year in the near future -- and we can throw in a more generous 15% estimate, too. Here are Dell's expected EPS levels at 12% and 15% growth rates:
12% 15% growth2004: $0.90 $0.922005: 1.00 1.062006: 1.12 1.222007: 1.26 1.402008: 1.41 1.612009: 1.58 1.852010: 1.77 2.13
Based on these numbers and the current stock price of about $32 per share, here are the earnings yields you can expect:
12% 15% growth2004: 2.8% 2.9%2005: 3.1 3.32006: 3.5 3.82007: 3.9 4.42008: 4.4 5.02009: 4.9 5.82010: 5.5 6.7
The numbers above suggest that if you bought shares of Dell at the current price of about $32, by 2010 your earnings yield on the stock would top 5% (assuming 12% growth) and 6% (assuming 15%). But that's a long time to wait, when you've got risk-free alternatives offering around 3% and other stocks offering higher earnings yields. (It's instructive to see how long it takes a stock's earnings yield to meet your desired level, or surpass risk-free rates, at expected growth rates.)
Given conservative estimates of EPS growth rates, Dell doesn't appear to be a bargain, at least not at the current stock price. But its past growth rates have been extraordinary, and may well continue to be high. If so, then the current stock price becomes more attractive. Still, based on the considerations in this article alone (which are far from enough on which to base an investment decision), if you'd only be planning to own Dell for a few years, you can probably find some more promising places for your money.
Now that you've got this tool under your belt, remember that the earnings yield is just one of many investor tools. It shouldn't dictate any decision for you, but it can be a helpful factor when evaluating a company.
For more on the earnings yield, read this Warren Gump article.
To learn more about how to decipher financial statements and evaluate companies, visit our Fool's School or take our online seminar/how-to guide, How To Crack the Code: Read Financial Statements Like A Pro. (We've got a big bunch of inexpensive online seminars that have received high marks from participants -- they come with money-back guarantees, too.)
You can also find some exciting and promising investment prospects in Fool co-founder Tom Gardner's brand-new newsletter, Motley Fool Hidden Gems. Check it out!
Selena Maranjian is smarter than a speeding bullet and faster than a tall building. For more about her, view her bio and her profile. You might also be interested in books she has written or co-written: The Motley Fool Money Guide and The Motley Fool Investment Guide for Teens . The Motley Fool is Fools writing for Fools.