Monday, August 29, 2011

How to use Earning Yield to buy stocks

Earning yield is a great financial ratio which can be used very effectively to evaluate a stock. The process of calculating this ratio is very simple, first calculate the ‘Earning per share (EPS) and then divide EPS with current market price of stock.

The value you wil obtain is in percentage. The reported net profit (PAT) as declared by the company in last 12 months of operation can be taken as earning. Number of shares outstanding in the market is also declared by companies in their financial reports. So collect these two values and calculate EPS.

PATNo of Shares OutstandingEPSMarket PriceEarning Yield
Company A$10010 Nos$10$1506.6%
Company B$15010 Nos$15$12012.5%

Any investor who has been into share market investing must have come across Price to Earning (P/E) ratio in the past. Earning Yield is just an inverse of the famous P/E ratio. As an investor one would like to see a higher earning yield in order to decide whether to buy this share or not. In the above example you will see that Company A has a earning yield of 6.6% where as Company B has a yield of 12.5%, hence Company B certainly becomes a better buy.

The significance of using Earning Yield to evaluate a share is that it helps investors to know whether a share is over valued or are available at a bargain price. In the above example, Company A has earning yield of 6.6% and Company B has 12.5%, what does it mean to an investor. In order to answer this question, one should know a third comparing percentage called as “risk free return” of the market.

Generally speaking this risk free return in nothing but the returns that investors have access to in the form of Government Bonds, Bank Deposits etc. Suppose that the present levels of “risk free returns” is 7.5%, which means that as an investors you have a choice to invest in (say) a bank deposit which will give a risk free return of 7.5%. But Company A is showing an earning yield of only 6.6% which is lower than risk free return, I this you must think that why you will rather invest in shares of company

A (which is risky) if you are getting better risk free return in the market. Similarly for company B, you will get a premium of taking a risk by investing in its shares. The expected returns can be 12.5% which is far higher than risk free returns of the market. Hence Company B is a better bet for an investor.
The other advantage of using Earning Yield is that it gives investors an option to wait without taking an impulsing & hasty decision. Investors can wait till the market price of (say Company A) falls bringing its earning yield higher than the risk free return. At such price levels investors can enter the market and buy those shares.

Important Note
As an investor one must be careful that investing in stocks just on basis of Earning Yield is not wise. Earning yield is just an indicator that whether the market price levels of stocks is undervalued or over values, but it says nothing about whether the company is ‘good enough’ to generate future profits. A company which has high profitability can be considered as a good company. In order to know whether a company is profitable one must know how to calculate the Return on Capital (ROC) of a company. A company which has higher ROC and Yield automatically makes it a good choice of buying.
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