Currently, the common measurement of this metric is what is called the Earnings Yield [EY]. It is simple to determine, and is just the reverse of the PE ratio. Rather than dividing the price by the earnings, to get the EY we divide the earning by the price. That tells us the return in earnings for each dollar we invest. An example: We purchase a stock for $10 that earns $1 a year. The PE ration is 10 ($10 /$1), that means we are paying ten times the earnings per share for each share. The EY is 10% ($1/ $10). It tell us that for each dollar we pay, this stock will return 10% to us in earnings. This is a good gauge, but I feel totally inadequate. Why?
In a word, dividends. Let's look closer. What are dividends? They are monies paid from retained earnings (money in the bank) to shareholders. Isn't this a return to us? What the company is essentially saying is, "our business requires "x" dollars to function and grow, but our earnings are large enough where we have "x plus" in the bank, so here you go - as an owner, take some." Again, we have to look at the purchase of a share of stock as a purchase of the whole company. If we bought the whole company, we would receive all the money in the bank (retained earnings). All dividends are is a partial payment of that to us for buying part of the company. When I figure my Total Return Yield [TRY], I take the EPS (earnings per share) and add the dividends per share to it then divide by shares outstanding.
The argument from accountants will be that dividends are paid from earnings that do not need to be reinvested in the company, so to count them again is in essence "double counting" them, which will artificially inflate my return. That argument is technically correct by accounting standards, but not correct for our uses. (Let's not get stuck on that point, gang, these are the same people who did not classify stock options to as an expense to the company. Yeah... employee compensation was not an expense?).
Here is why I claim it is incorrect to make their assumption: If we were buying the whole company and going to value it, part of our valuation would include a value of the money in the bank (retained earnings). So if we are to believe the accountants argument, because we are only buying a portion of the company, we should not value the return of that money in the bank (dividends) to us? The way retained earnings (money in the bank) are treated for accounting purposes does not quantify what years earnings they represent.
Why does this matter? Let's assume I buy stock in a company that earns $1 a share and pays me a $1 dividend. The next year I own it, earnings drop to $0 for whatever reason, but they still pay me my $1 dividend. Where did the $ come from? Prior years' earnings. The point here is that when you buy a stock that pays a dividend, you are also buying a claim to unused portions of prior years' earnings that are paid to you in the form of that dividend. We must include that value in our return. This process does admittedly favor dividend paying stock so we need to look closely at that:
There are only three reasons a company will not pay a dividend, and two are bad:
1. No money available (bad business losing $$)
2. The business requires so much money to grow, innovate and maintain market share that it needs to re-invest almost all of the earnings, leaving none for dividends (think most tech. companies)
3. The managers are able to earn such a far superior return on the retained earnings that it is in the shareholders' best interest for them to keep and invest it (Rare: think Warren Buffet and Eddie Lampert - Sears Holdings Corporation (SHLD).
Those companies that pay dividends are in the types of businesses that generate profits in excess to what is needed to both maintain and grow the business. They return a portion of the excess to us, the owners, and keep some "for a rainy day." These are businesses we want to be looking at more closely as they are more likely to have durable competitive advantages than those who do not. Now of course this is not a "all of them" scenario, but with thousands of stock to look at, this helps us begin to narrow the search.
Let's do a real life comparison. We have $1000 dollars and want to invest it. We are looking at Value Plays Portfolio pick Altria (MO) and we will compare it to Starbucks (SBUX). For our $1000, we can buy 11.7 shares of MO or 30.1 shares of SBUX at current prices. The question is now, what do we get for the money we spent? After one year, in MO we get $66.80 in earnings and $40.25 in dividends for a total of $107.05 or a TRY (total return yield) of 10.75% ($10.75 / $1000). In SBUX we get $21.93 in earnings and no dividends for a TRY of 2.2%.
Which company presents a better value to you? MO, of course. Now the argument for SBUX will be that the company is growing faster so the stock price will appreciate more and SBUX owners will see more profits. Consider this, though: in order for SBUX holders to make up the difference, their shares need to appreciate $2.85 each or 8.7% more than MO shares to make up the difference. "Big deal, only 8%," you say? It is a big deal when you consider that since the beginning of 2005, MO shares are up 40% and SBUX shares just 12%.
Where does this leave us? This cannot be used as a "be all end all" tool. It does not take into account the future growth of the business and what you are paying relative to that growth. It does however, give us a snapshot of value the day we purchase a share of the company and is but another piece of the puzzle. If we find a business selling close to its growth rate, it is considered cheap in comparison to its growth. TRY will tell us its value relative to the earnings and retained earnings we can expect to receive.