Fool's School The Earnings Yield

Looking at a company's price-to-earnings ratio, or P/E, to get an idea of its relative price can be useful. Calculating the P/E's inverse - the "earnings yield" - can be enlightening, too.

As an example, to calculate the P/E of Home Surgery Kits Inc. (ticker: OUCHH), you simply divide the current stock price by the annual earnings per share (EPS). If its current annual EPS is $2 and the stock is trading for $80 a share, the P/E is 80 divided by $2, or 40. While 40 seems steep, it's not meaningful until you compare it with the P/E ratios of industry peers and consider the firm's health, competitive position and growth prospects.

To calculate Home Surgery Kits' earnings yield, just reverse the P/E ratio, dividing the annual EPS by the current stock price. $2 divided by $80 equals 0.025, or 2.5 percent. Compared with risk-free Treasury bond rates of roughly 3 percent to 4 percent, this does not seem like a bargain. But remember: Whereas bond rates are fixed, earnings typically grow. If Home Surgery is expected to increase earnings by 10 percent per year, in 10 years its EPS should grow to $5.19. If we bought our shares at $80, our effective earnings yield would become 6.5 percent, considerably better ($5.19 divided by $80 is 0.065).

It can be instructive to see how long it takes for the growing earnings yield to pass the current 30-year bond rate, or your target rate. If your desired rate of return for your invested dollars is 12 percent, it will take about 18 years of earnings growth before the earnings yield of Home Surgery beats that target - if earnings actually grow at the estimated pace. You can probably find other investments that will get you there more quickly. With riskier companies, you might look for them to pass your target rate sooner rather than later.

The earnings yield can help you think more clearly about your expectations for investments. But remember always to examine many measures of a company, and not just one or two.