With the market pulling back last week, there's been a lot of discussion on whether the market is overvalued or not.
A good way to answer this is to look at the earnings yield.
A stock's earnings yield measures just that, the anticipated yield (or return) an investment in a stock could give you based on the earnings and the price paid for the stock.
The calculation is the inverse of the P/E ratio:
The P/E of course is the Price / Earnings
So a stock trading at a Price of $35 with Earnings of $3 has a P/E ratio of 11.67. This means it's selling at 11.67 times earnings. Another way of looking at it is you're paying $11.67 for $1 of earnings.
The Earnings Yield is calculated as Earnings / Price
Using the example above, a stock with $3 of Earnings trading at a Price of $35 ($3 / $35) has an earnings yield of 0.0857 or 8.57%. The Earnings Yield, also known as the E/P Ratio, is expressed as a percentage. So a yield of 8.57% would also mean 8.57 cents of earnings for $1 of investment.
Of course, this is all potential, because prices and earnings change.
How To Use It
The most common way people will use this ratio is to compare it to other stocks and to compare the yields to the 10 Year T-Bill.
Conventional wisdom has it that if the yield on the stock market (S&P 500 for example) is lower than the yield on the 10 Year Treasury, then stocks might be considered overvalued.
If the yield on the S&P 500 is greater than the 10 Year T-Bill, stocks would be considered undervalued.
The theory behind this is that Bonds and Stocks are competing for investors' dollars. And to attract investment interest in stocks, a higher yield needs to be paid to the stock investor for the extra risk he or she is assuming compared to the virtual risk-free investment offered in US-backed Treasuries.
If earnings go up, the yield goes up. If earnings go down, so does the yield.
Prices also impact the yield, but they move inversely. If Prices go up, the yield goes down. And if prices go down, the yield goes up.
Forecasting Market Upturns and Downturns with the Earnings Yield
In June of 2007, the yield on the 10 Yr. T-Bill was 4.95%.
However, the earnings yield on the S&P 500 was 4.19%.
Not much of a risk premium on a risk based investment.
Remember, if the earnings yield on stocks is below the T-Bill rate, stocks are considered overvalued. (I should point out that within months, the market began to falter.)
I also happened to write about the earnings yield in March of 2009. This time, the earnings yield was high. Back then, the earnings yield on the S&P 500, using the 12 Month Projected Earnings Estimate, was 9.51%, compared to the 10 Yr. Treasury of 2.89%.
With yields well above the 10 Year, conventional wisdom said that stocks were 'undervalued'. Of course, they could have continued to get more undervalued. But the market was quickly bid up - resulting in one of the largest rallies we've ever seen.
So where is it now?
Currently, the earnings yield for the S&P is 6.29%, compared to the 10 Year Treasury of 2.44%.
So stocks are still the more attractive investment, assuming you're ok with the risk that comes along with it.
The screen I'm running today looks for the following:
• Price greater than or equal to $5
• Volume (Avg. 20 Day Shares) greater than or equal to 100,000
• Earnings Yield greater than or equal to 7%
(For those using the Research Wizard, the calculation looks like this:
That's the 12 Month Forward Looking Estimate (i642) divided by the Current Price (i5))
• 12 Month Projected Growth Rate greater than or equal to S&P 500
• Zacks Rank less than or equal to 2
Here are 5 stocks from this week's screen:
GILD Gilead Sciences
(9.01% Earnings Yield)
(8.03% Earnings Yield)
MGA Magna Int'l
(8.46% Earnings Yield)
RFMD RF Micro Devices
(8.39% Earnings Yield)
UAL United Continental Holdings
(12.33% Earnings Yield)
Get the rest of the stocks on this list and start using the Earnings Yield in your own screens. Find the stocks that can give you the best returns. You can do it.
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