This post is focused on two important investment principles that I believe most people overlook in their analysis and investment decision making; Earnings Yields and Expected Value. I am also guilty of not using these concepts to there fullest potential. In fact that is why I am writing this particular blog post, I noticed some conceptual gaps in my investment analysis.
Almost everyone I know uses the price to earnings ratio (P/E) to understand a valuation. Now this is good and a perfectly good way to understand valuation of a stock but seeing it in the same formation-as price over earnings- is leaving out some key information. What the P/E does for an investor is lets them know just how much they pay for one dollar of that company's earrings. This is useful for the layman investor in comparing to other company's stocks and to the past valuation of the same stock. What most investors are missing is the opposite side of the coin, the inverse of the P/E or earnings yield. This is simply just a company's earnings over the current stock price. The difference is that it sheds a different perspective on the valuation as it will provide a percentage of how much an investor will yield in earnings based on the amount of money one invests. For example lets say a stock is trading at a P/E of 15x, so you are pay $15 for every $1 of earnings, now lets reverse that to get the earnings yield:
P/E of 15x = 15/1
E/P then is 1/15
Now 1/15 is equal to 0.0667 or 6.67%.
The great part about thinking about the earnings yield is it can also be compared stock to stock and throughout time but there is an added perspective to it; you can compare it to other yielding financial instruments like bonds. Now we have a percentage yield an investor can see what the premium the market is giving for last years earnings and future earnings over something safer like treasury bonds. In this way you can see what you getting compared to another asset. The reason I think most investors don't even think about the earnings yield is 1.) it is not presented on many investment research websites and 2.) therefore it takes someone more time to calculate it out. Thats why made myself a earnings yield to P/E table to reference quickly. It looks like such:
The second principle that I try to use as much as possible is expect value. This is the idea of using probabilities along with the value of outcome to make decisions. To be honest this principle is the harder to execute as it requires a different process of decision making, one that I am trying to in corporate as much as possible in my life and investment decisions.
Decision making using expected value is just the same of taking the probabilities of outcomes happening multiplied by the values you expect from said outcomes. For example:
Probability of Happening is 60%
Value of Outcome is +$1,000
Outcome B :
Probability of Happening is 40%
Value of Outcome is -$500
(.60 x $1,000) + (.40 x -$500) = $400
If the expected value is a positive number the theory says you should make it as it is probable to be a positive outcome and vice versa for negative values. This is a great principle for investment decisions for two reasons; 1.) it makes and investor assign probabilities to outcomes rather than just guessing and 2.) it allows you to compare to investments numerically. I personally am trying to work this theory into my investment strategy more and more as it is better than estimating subjectively. Using the expected value approach to investment decision making will also allow me to make money allocation decisions with limited capital more efficiently and track my analysis of probabilities over time.