Yielding profit

The earnings yield of a stock can help investors compare its performance with that of other asset classes, especially debt instruments like g-secs.

twitter-logo Sameer Bhardwaj        Print Edition: March, 2010

Most equity valuation ratios help investors identify undervalued stocks relative to other stocks in the same industry. What if one wants to compare the performance of stocks with other asset classes like bonds, fixed deposits and government securities (gsecs)? The yardstick that helps one compare stock and debt instruments is yield. The yield of debt instruments is derived from periodic cash flows, market price and time till maturity.

The yield of a stock is known as earnings yield. For instance, if the share price is Rs 100 and EPS is Rs 2, its earnings yield will be 2 per cent. An alternate method of calculating earnings yield is to consider the inverse of the price to earnings (PE) ratio. For instance, a stock with a PE of 20 times will have an earnings yield of 5 per cent (1/20). Analysing g-sec yields and earnings yields helps in estimating the equity risk premium, which is the additional return that stock markets must offer (over and above the risk-free return) to compensate for the numerous risks involved.

The difference
The difference between earnings yield and g-sec yield is vital in determining an undervalued or overvalued stock. As the difference increases, the stock becomes more undervalued because it is generating an adequate risk premium. On the other hand, if the difference narrows, it indicates overvaluation.

Let us consider an example. The one-year average g-sec (10-year Indian government bond) bond yield is 6.5 per cent. Without bearing any risk one can earn 6.5 per cent, so a stock will appear attractive only if its yield is higher than the risk-free rate. A stock with a PE of 10 will appeal to investors more than the stock with a PE of 12 as the former is delivering a risk premium of 3.5 per cent, which is higher than the 1.83 per cent risk premium offered by the latter. The same rules can be applied while considering the earnings yield of a stock index vis-à-vis the g-sec yield. The higher the difference, the cheaper is the stock market relative to bond market, and vice versa.

Consider other aspects
Factors like a company's growth potential and business prospects should also be analysed. A stock's yield may be lower than the g-sec yield because of investor expectations. The current high price of the stock may be due to expectations of extraordinary growth in future earnings. This happens because the cash flows of g-secs are fixed, while it is variable for firms. A company with a current yield of 4 per cent, if its earnings are expected to grow at a rate of 15 per cent a year, will surpass the 10-year g-sec yield of 6.5 per cent in just 4 years.

Earnings yield should not be confused with dividend yield, which is calculated by dividing the dividend paid per share by the current market price. The former analyses stocks across asset classes, while the latter assesses a stock's performance relative to the same asset class. Earnings yield helps in judging whether a company is earning adequate profits and can afford dividend payments.

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