When investors are looking for attractively valued stocks to invest in, one of the best and easiest metrics to evaluate is earnings yield. This metric is simply the inverse of the P/E ratio where you divide the company's earnings by its current price (E/P). In the video in my most recent article found here, I focused extensively on an earnings yield above 6% as a minimum threshold for fair value.
However, the critically important words in that statement are "above" and "minimum" threshold. In actuality, and with all other things being equal, the higher the earnings yield the better. And in truth, I prefer an earnings yield of at least 7% or better before I would actually consider investing.
Unfortunately, although I stand by that earnings yield threshold, numerous comments on my recent article indicated to me that many readers did not totally understand what I was suggesting. Consequently, I felt compelled to offer this article in an attempt to clarify the relevance and the usefulness of the earnings yield metric.
For starters, current earnings yield is a measurement of valuation relative to the company's current earnings power, but it does not necessarily indicate a good investment. Instead, I simply utilize earnings yield as a method for identifying companies that are reasonably valued. However, there are many other fundamental metrics that I will always consider once I have identified a good earnings yield.
Stated differently, a high earnings yield does not imply a high future total return potential. In fact, depending on whether earnings are growing or shrinking, a company with a high earnings yield could actually be a very poor future investment choice. Therefore, like all fundamental metrics, earnings yield should never be utilized in a vacuum. Although it might indicate a low current valuation, there are many reasons and scenarios where that low valuation might be justified because of weak or poor future fundamental performance.
To summarize, an earnings yield of 7% or better (this is a guide - not an absolute) will immediately identify a company with a low and possibly attractive current valuation. However, whether the stock is a good investment or not will be relative to the company's other fundamental strengths and future growth potential. Therefore, the earnings yield should be thought of as an initial check in order to find fairly valued common stocks. However, a high earnings yield alone is just the beginning of a more comprehensive research and due diligence process, and not the endgame.
Earnings Yield to Avoid Making Obvious Mistakes
Whenever I am looking for common stocks to invest in, the initial step of my research process is to look for attractive valuation. This is predicated on the notion of no matter how much I like a business, I am never willing to pay more than I believe that business is worth. As an aside, this is pretty much how I go about making a decision to purchase anything. As the old adage goes, "price is what you pay value is what you get."
This value orientation applies to any category of common stock I am endeavoring to invest in. Whether it is a dividend growth stock, a high-growth stock, large-cap, small-cap or real estate investment trust, etc., I am only willing to invest at a fair price. As I have stated numerous times, I believe this both mitigates long-term risk while simultaneously enhancing long-term returns. There is always an element of risk when investing in common stocks; therefore, I believe it only makes sense to control risk as much as possible.
Paying attention to fair valuation is one of the easiest and most successful ways I have found of doing that. Excessive valuation ranks among the most easily avoidable risks of stock investing, and as such, to me it is an unnecessary risk to take. This concept is further supported by the reality that it is easier to determine the intrinsic value of a business within a reasonable range, than it is to guess where the stock price might go in the short run.
Earnings Yield for Valuation Not Total Return: A F.A.S.T. Graphs™ Video Review
The following F.A.S.T. Graphs™ video will illustrate how the earnings yield metric can be utilized to identify fairly valued common stocks. However, it will also illustrate that the primary benefit of utilizing the earnings yield metric is to screen for low valuation. Additionally, it will also illustrate how and why fair valuation only represents the first step prior to a more comprehensive research and due diligence process.
Moreover, I will further attempt to illustrate that fair valuation will always represent a sound risk mitigation tool, but not necessarily a tool to solely identifying good investments. Although I will personally never invest unless attractive valuation is apparent, I will also never personally invest just because valuation is reasonable. There are many other factors that must be taken into consideration and I will share a few in the video presentation.
Summary and Conclusions
Successfully investing in common stocks is always a puzzle comprised of many pieces before a clear picture can be produced. Each piece of the puzzle is important in its own right and must be placed in the proper spot before the puzzle can be solved. Fundamental metrics represent the most important pieces to the investing puzzle. However, just as it is with any puzzle, no piece is actually more important than any other. They all must be placed appropriately before the mission is accomplished.
The earnings yield metric is an important one that investors can utilize to begin solving their investment puzzles. On the other hand, you still have to place all the other pieces in the correct order and placement. Every fundamental metric is relative to every other, and as such, they are all important and they can all be quite useful when utilized properly and in the proper context.
Finally, as it relates to sound valuation, I believe it's important to recognize that neither high nor low valuation necessarily defines the company. In the long run, a common stock will perform in relation to the operating results (earnings, cash flows, dividends, etc.) it achieves on its shareholders' behalf. However, in the short run, price can be disconnected from fundamental value - over or under.
To some extent, management can control operating results, but they cannot control stock price movement. Consequently, a great business can become undervalued or overvalued in the short run. Conversely, a lousy business can also be overpriced or underpriced.
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Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.
Disclosure: I am/we are long AMGN,CAH,CBI,ABBV.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.