Earnings Yield

Definition

Earnings yield is a financial metric that represents the earnings per share (EPS) of a company divided by its market price per share, expressed as a percentage. This figure helps investors assess the relative attractiveness of a company's stock compared to other investments, particularly in relation to the equity risk premium, which is the extra return expected for investing in stocks over risk-free assets.

5 Must Know Facts For Your Next Test

1. Earnings yield is calculated as $$rac{EPS}{Market Price}$$, providing a clear view of how much earnings are generated per dollar invested in the stock.
2. A higher earnings yield indicates a potentially undervalued stock, suggesting that it may provide better returns relative to its market price.
3. Investors often compare earnings yield to the risk-free rate or the equity risk premium to determine whether a stock is worth the investment risk.
4. Earnings yield can fluctuate based on market conditions, investor sentiment, and company performance, affecting stock attractiveness.
5. The metric is especially useful during periods of market volatility when assessing potential returns against other investment options becomes critical.

Review Questions

• How does earnings yield help investors evaluate stocks in relation to equity risk premium?
  • Earnings yield serves as a benchmark for investors by comparing the earnings generated from a stock relative to its market price. When assessing equity risk premium, investors look at whether the expected return from stocks justifies the risk taken compared to safer investments. If the earnings yield is higher than the risk-free rate, it may indicate that investing in stocks could provide sufficient compensation for taking on additional risk.
• Discuss the implications of a declining earnings yield for an investor's portfolio strategy.
  • A declining earnings yield may suggest that stocks are becoming overvalued or that company earnings are under pressure. This could lead investors to reassess their portfolio strategy, potentially reallocating funds from equities to safer assets or seeking undervalued stocks with higher earnings yields. Monitoring this metric can signal a shift in market sentiment and guide investment decisions based on perceived risks and returns.
• Evaluate how changes in market conditions might affect the relationship between earnings yield and equity risk premium.
  • Changes in market conditions can significantly influence both earnings yield and equity risk premium. For instance, during economic downturns, corporate earnings may decline, leading to lower earnings yields, which can result in investors demanding a higher equity risk premium to compensate for increased uncertainty. Conversely, in bull markets with rising earnings, earnings yields may improve relative to historical norms, potentially narrowing the equity risk premium as investors feel more confident about returns from stocks compared to bonds or other safe investments.

Related terms

Equity Risk Premium: The additional return that investors expect to receive from investing in stocks compared to risk-free securities, compensating them for the extra risk.

Price-to-Earnings Ratio (P/E): A valuation ratio calculated by dividing a company's current share price by its earnings per share, used to gauge if a stock is over or undervalued.

Discount Rate: The interest rate used to determine the present value of future cash flows, essential for valuing investments and assessing expected returns.