Want to check if a share is cheap? Work out its earnings yield…

Julie Brownlee, Fsp Invest, 06 Feb. 2015

Tags: earnings yield, what is earnings yield, financial ratio, using earnings yield, finding cheap shares, how to find cheap shares,

If you want to invest, it’s important that once you decide what shares you want to buy you don’t just leap in at any price. You want to buy when the share is cheap.

By doing this, you’re maximising the upside potential of your investment.

So how can you see if a share is cheap or not?

Read on to find out how to use a company’s earnings yield to check just that…

What is the earnings yield?

A company’s earnings yield compares its earnings before interest and tax with its enterprise value.

Earnings before interest and tax, or EBIT, is a company’s trading profits.

Enterprise value (EV) is what you get if you add up a company’s equity and its debt, and minus its cash. You can read more about enterprise value here.

When you compare these two figures (EBIT/EV), you get the earnings yield for the business as a whole, as an interest rate.

How to use earnings yield

The higher the interest rate of the earnings yield, the cheaper the share is.

What’s so useful about a company’s earnings yield is it gives you a lot of information about what you’re paying for the assets of a business.

This is down to the two factors in the calculation:

  • The enterprise value tells you how the company finances itself.
  • The EBIT tells you about the profits it generates.

The advantages of using the earnings yield

If you only look at equity, which is what the price earnings (PE) ratio does, you can make mistakes as it can be misleading.
This is because if a company has a lot of debt, its PE ratio can make it look cheap.

The earnings yield also lets you compare companies that have different financing structures. It also ignore the different tax rates companies pay.

PE ratios don’t.

The one thing to bear in mind with using the earnings yield is that it doesn’t work well with financial companies, like insurance companies and banks.

So there you have it. If you want to check a share is cheap, work out its earnings yield.

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