What it means
Most investors meet valuation through the price to earnings ratio, which says how many years of current profit you are paying for a share. Earnings yield asks the same question the other way round: for the price you pay, what percentage return does the underlying business currently produce?
A price to earnings ratio of 20 is the same statement as an earnings yield of 5%. Flipping the ratio matters because it puts equities on the same scale as everything else competing for money.
A treasurer weighing a share buyback against paying down a loan at 6% can compare directly if the company's own earnings yield is 8%. Fund managers use the same logic when they set the earnings yield of an index against the yield on government bonds.
The measure is normally calculated on earnings per share divided by the current share price, though it can equally be computed at the whole-company level as net profit divided by market capitalisation. Analysts choose between historic earnings, which are certain but backward-looking, and forecast earnings, which are more relevant but depend on estimates that may be wrong.
Earnings yield is not cash in your pocket. Unlike dividend yield, it counts profits retained inside the business as well as those paid out, so a company with a 7% earnings yield and no dividend is reinvesting the whole amount.
Whether that is good news depends on how well the company invests, which the ratio itself says nothing about. Value investors often prefer earnings yield precisely because it behaves sensibly at extremes.
A company with almost no profit produces an absurdly high price to earnings ratio that is hard to interpret, while the same company simply shows an earnings yield near zero. A common variant, the earnings yield used in some screening methods, replaces net profit with operating profit and price with enterprise value, which removes distortions caused by different debt levels.
In practice
Real-world examples.
Example
A pension fund committee compares an equity portfolio with an earnings yield of 6% against corporate bonds yielding 5.5%. The small gap prompts a debate about whether the extra risk of shares is being adequately paid for at current prices.
Example
A private company owner is offered $12,000,000 for a business earning $1,500,000 after tax, an earnings yield of 12.5%. She compares that with the 4% she would earn on cash after a sale and uses the gap as the starting point for negotiation.
Example
A corporate treasurer evaluates a buyback of the company's own shares at an earnings yield of 9% versus repaying a term loan costing 6%. The buyback looks better on that measure, though the team also weighs the loss of balance sheet flexibility.
Think of it
“Earnings yield is like measuring what percentage of your investment comes back as earnings each year.
Formula
Calculation
Formula: Earnings Yield = Earnings Per Share / Market Price Per Share, expressed as a percentage.
Suppose a listed distribution company trades at $50.00 per share. Over the last twelve months it reported net profit of $64,000,000 with 20,000,000 shares in issue, so earnings per share are $64,000,000 / 20,000,000 = $3.20.
Earnings Yield = $3.20 / $50.00 = 0.064, or 6.4%.
The equivalent price to earnings ratio is $50.00 / $3.20 = 15.6, and the two statements carry identical information. If the share price rose to $80.00 with profit unchanged, earnings yield would fall to $3.20 / $80.00 = 4.0%, telling an investor that each dollar invested now buys noticeably less current profit than before.Case study
Seen in the real world.
Fernwood Instruments is a fictional listed manufacturer used here as an illustrative case. Its shares trade at $50.00, earnings per share are $3.20 and the earnings yield is 6.4%, which the finance director presents at a board meeting alongside the 6% coupon on the company's outstanding bonds. The comparison is used to argue that returning capital to shareholders is roughly as attractive as retiring debt.
A non-executive director pushes back with a useful challenge. Earnings yield counts accounting profit, but Fernwood's profit includes a large non-cash credit from revaluing a property, and cash earnings are closer to $2.40 per share. On that basis the cash-adjusted earnings yield is $2.40 / $50.00, or 4.8%, comfortably below the cost of the debt.
The board defers the buyback and repays $20,000,000 of bonds instead. Twelve months later the property credit reverses, reported earnings fall, and the original comparison would have looked badly wrong. This illustrative example shows why earnings yield is a starting point for a conversation rather than the end of one.
Watch out
Common mistakes.
- Confusing earnings yield with dividend yield. Earnings yield covers all profit including the part retained in the business, so it is usually the higher of the two.
- Comparing earnings yields across companies with very different debt levels. Debt magnifies earnings per share, so a highly geared company can show an attractive yield while carrying far more risk.
- Using a single year of unusual profit. One-off gains or losses distort the yield badly, which is why many analysts use a normalised or multi-year average earnings figure.
Questions
People also ask.
Is a higher earnings yield always better?
Not necessarily; a very high yield often reflects market scepticism about whether those earnings will continue, so it can signal risk rather than a bargain.
How does earnings yield relate to the price to earnings ratio?
They are exact reciprocals, so an earnings yield of 5% corresponds to a price to earnings ratio of 20.
Can earnings yield be negative?
Yes, if the company is loss-making, and this is one reason some investors prefer it to the price to earnings ratio, which becomes meaningless with negative earnings.
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