Investors have a couple of basic choices when it comes to putting their money to work. They can buy bonds and earn the yield (interest) from those bonds. That’s a known quantity. Or, they can buy stock and have a claim on the earnings of the company and, even, receive some of those earnings in the form of dividend payments. But how to know which one is better?

One way is to use the earnings yield. As a share holder, you have a claim on the earnings of the company. But what is that claim as a portion of your investment? The earnings yield tells you. Divide the earnings per share (EPS) by the share price when you bought. The result is the earnings yield and is just the inverse of the P/E ratio.

By turning P/E into a percentage we’ve already accomplished something useful. In theory, this percentage represents the return on every dollar invested that should be earned by the company, assuming earnings remain flat (a questionable assumption to be sure). This percentage can then be compared directly against the returns offered by alternative investments, such as interest on a bond or savings account. The utility is greater than that provided by the P/E ratio. This is one reasons why earnings yield is better than P/E.

In fact, many mutual fund managers compare earnings yields with 10- or 30-year Treasury-bond yields to get an idea of how expensive stocks are. Indeed, some academic research indicates that over time earnings yield has been one of the better indicators for judging if the market is over- or undervalued.

As a working example, let’s take Keppel Corporation:-

EPS: $1.245

Current Price: $11.39

Earnings Yield = EPS / Price = $1.245 / $11.39 = 10.93%

Hence, if your choice was between that and a bond yielding 6%, then Keppel Corporation could be said to be the better investment, on a yield basis.

Of course this is not the actual return on the investment, just the claim on earnings expressed as a percentage of the original investment in the company. The actual return comes from cash the company distributes to its shareholders either through dividends or share repurchases, as well as from appreciation of the stock price.

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