The P/E ratio and earnings yield ratio of a stock can reveal much about the pricing and growth prospects. Both these measures are widely used by investors in stock valuations and company performance analysis.
Let us discuss what is the P/E ratio, Earnings Yield, their key differences, and which one is a better measure.
What is P/E Ratio?
The Price to Earnings (P/E) ratio is a measure of the price of a stock against the earnings per share (EPS). It states the relationship between the price and EPS of the stock.
The relationship can be described as historic results as well as forecasts of a company’s performance. It is also called the price multiple or earnings multiple of a stock.
The P/E ratio is widely used by managers and analysts to analyze the financial performance of a company. It is also widely used in appraising stock pricing and analyzing whether a stock is undervalued or overvalued.
Therefore, it can be used in internal performance appraisals as well as external benchmarking comparisons. However, like any other financial ratio, it shouldn’t be used as a standalone metric.
P/E Ratio Formula
The price-to-earnings ratio of a company can be calculated with the help of the following formula:
P/E = Current Stock Price/Earnings Per Share = P/EPS
If the earnings per share figure are not readily available,
Earnings Per Share = Total Earnings of the Company / Total Shares Outstanding
EPS= Net Earnings/No. Of shares
Let’s consider a real-world example of Apple stock to calculate its P/E.
The stock price of Apple was $ 136.53 and its earnings per share were $6.05 on June 20 2022 for the financial results declared for Q2.
P/E = Price/EPS
P/E = $136.53/6.05 = 22.56
Since then, the share price of Apple has increased to $144.80. So, its current P/E is 25.14.
How Does a P/E Ratio Work?
The interpretation of the P/E ratio is more important than its calculations. A P/E ratio tells us how much investors are willing to pay for $1 of a stock price.
This is the reason this ratio is also called the price multiple. Conversely, it also shows how much investors can expect to make with each $1 invested in a stock.
However, analysts must dig deeper and understand the factors behind the P/E ratio. If the P/E ratio of a company is unrealistic, it means the stock is either undervalued or overvalued.
Many analysts use average P/E ratios of stocks for the previous 10 or 30 years to get a clearer picture as well.
The P/E ratio of Apple was 22.56 and has increased to 25.14. For the same period, the P/E ratio of Walmart was 26.30 and is currently 23.15.
The P/E ratios of both these companies look similar. However, both companies are from different industries and with different financial histories. Therefore, we cannot compare the P/E ratios of these companies directly.
Therefore, the right method will be to compare the P/E ratios of both stocks with their counterparts in the same sector. Also, we can compare the P/E ratio of the same stock with its historic results for performance comparisons.
The forward P/E analysis come through the forecasted earnings of a company. These forecast earnings calculate the estimated EPS of the company first.
Then, we can estimate the forward P/E of a company using that figure. The price of the stock at future date is also an estimation.
As with any other forecast method, the forward P/E ratio also depends largely on estimates. However, it is still a useful method of analyzing the performance of a stock with actual and estimated ratio comparisons.
The trailing P/E ratio is the analysis of stock price and earnings over historic results. It can be for a quarter, a year, or several years depending on the analysis.
Although the trailing P/E ratio provides accurate results, it cannot predict the future performance of the stock. Historic results do not show how a company will perform in the future.
Nonetheless, analysts can use trailing and forward P/E ratio analysis to analyze the performance of a company and investment potential for investors.
What is Earnings Yield?
The earnings yield of a company refers to the measure of earnings it can generate with each dollar invested.
It creates a link between the investment and the return generated on that investment. It is described in percentage terms.
Earnings yield is reciprocal of the P/E Ratio. However, it does not calculate the stock price but helps in understanding the earning potential of that stock.
Managers and analysts can use earnings yield to understand the asset allocation and profits generated by the company. Investors use this ratio to measure their rate of return on investments.
Therefore, unlike the P/E ratio, it is not a price multiple but an earnings yield analysis.
Earnings Yield Formula
The formula for earnings yield is:
Earning Yield = Earnings Per Share/Stock Price = EPS/P
It is the reciprocal of the P/E ratio,
Earnings Yield = 1/P/E
The calculation of earnings yield requires the same steps as in P/E calculations. You’ll need to calculate the earnings per share of stock first by dividing the total earnings by the total outstanding shares first.
Then, divide that figure by the current stock price of the company. If the P/E ratio is readily available, you can divide it by one and calculate the yield in percentage terms.
Since the earnings yield is expressed in percentage terms, it’s easier to understand and calculate.
Earnings Yield Example
We can calculate the earnings yield of Apple using the same figures as used in the example above.
Earnings Yield = EPS/P
Earnings Yield = $6.05/ $136.53 = 4.43%
Similarly for Walmart,
Earnings Yield = 1/ (P/E Ratio)
Earnings Yield = 1/26.30 = 3.80%
Again, we can see that both companies’ earnings yield remains within the same range. However, as mentioned above, both companies come from different industries and the comparison should be performed for stocks within the same sector.
P/E vs Earnings Yield – Key Differences and Similarities
The price-to-earnings ratio and the earnings yield are both calculated using the same figures. Both ratios use the current stock price and the earnings per share of a company.
Both figures directly depend on the earnings of a company which can fluctuate anytime. It means both figures provide some sort of uncertainty.
However, since both metrics are reciprocal to each other, they provide contrasting results.
For instance, a higher earnings yield means a cheap stock and a lower earnings yield means an expensive stock. If the P/E ratio is higher, it means the stock price is higher and vice versa.
A key difference between the P/E ratio and earnings yield is their functionality with negative EPS. If a company’s earnings go negative for a period, its P/E ratio will be zero but show earnings yield (negative).
P/E vs Earnings Yield – Which One is Better?
Like other financial metrics, you cannot choose one over the other. Both financial ratios are useful but the P/E ratio is more commonly accepted everywhere.
One of the main advantages of the P/E ratios is that it shows stock valuation quickly. Investors look for the P/E ratio to analyze whether the stock is overvalued or undervalued.
Then, the concepts of trailing and forward P/E ratios help construct investment strategies as well. Investors can look into the historic results, compare them with the current ones, and forecast the coming ones.
Similarly, the P/E ratio is a good indicator to show the growth prospects of a company. However, companies in the early growth stages will show a lower EPS as compared to established companies.
On the other hand, the earnings yield is a good performance indicator of stocks with constant dividends. It can show distorted results with cyclic earnings and dividends.
Unlike the P/E ratio, it’s easier to compare the earnings yield of two stocks in different sectors and different sizes. For instance, you can compare the earnings yield of stocks against treasury bonds for investment appraisals.
Also, since the yield is a percentage figure, it’s easier to understand and analyze.
The drawbacks of earnings yield include uncertainty due to inconsistent EPS and dividends of a stock. It will not show comprehensive results for stocks without dividends and cyclic growth.
In short, the P/E ratio is more suitable for valuation analysis whereas the earnings yield is favored for return analysis.