Using Earnings Yield For Stock Picking


Piggy believes that “The Time is Stock’o Clock”, meaning that it is a good time to take positions in shares on the Zimbabwe Stock Exchange (ZSE) and Financial Securities Exchange (FINSEC). Following on the discussion on Price Earnings Ratio (PER), Piggy also recommends using Earnings Yield for Stock Picking. The Earnings Yield is an inverse of the PER and shows the percentage of how much a company earned per share. It is a useful metric to determine which assets seem underpriced or overpriced. The metric is calculated by dividing earnings per share for the most recent 12-month period by the current market price per share as shown below;

The most common practice is to compare the Earnings Yield of a broad market index (such as the ZSE All Share Index) to prevailing interest rates, such as the current Treasury yields. If the Earnings Yield is less than the rate of the Treasury Yield, stocks as a whole may be considered overvalued. If the Earnings Yield is higher, stocks may be considered undervalued relative to fixed income instruments. This approach is relevant given that investors in equities should demand an extra risk premium of several percentage points above prevailing risk-free rates (such as rates on Treasury Bills) in their Earnings Yield to compensate them for the higher risk of owning stocks.

As a general rule, a low ratio may indicate an overvalued stock while a high value may indicate an undervalued stock. It is also important to consider growth prospects for a company when using Earnings Yield. Stocks with high growth potential are typically higher valued and thus may have a low Earnings Yield even as their stock prices are rising.

It is also worth noting that sometimes investments with strong valuations and high PE ratios might generate more earnings over time and eventually boost up their Earnings Yield. This is what growth investors are looking for. On the other hand, investments with weak valuations and low PE ratios might generate less earnings over time and, in the end, drag down their Earnings Yield.

Earnings Yield may also be useful in a stock that is older and has more consistent earnings. Growth is expected to be low for the foreseeable future, so the earnings yield can be used to determine when it is a good time to buy the stock in its cycle. A higher than normal Earnings Yield indicates the stock may be oversold and could be due for a bounce. This assumes nothing negative has happened with the company.

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