Weighing up a share to invest in? Have a look at the company’s earnings yield first

Julie Brownlee, Fsp Invest, 28 Oct. 2014

Tags: earnings yield, what is earnings yield, advantages of earnings yield, pe ratio, ebit/ev, financial ratio

When it comes to investing in shares, it can be hard to know which companies you should research further or invest in.

A handy calculation to perform is the earnings yield. This gives you a figure that allows you to easily weigh up a company against other investment opportunities.

Let’s take a closer look at how the earnings yield works…

What is the earnings yield?

The earnings yield compares a company’s earnings before interest and tax (EBIT or trading profits) with its enterprise value (EV). Enterprise value is the market value of a company’s equity plus its debt, minus its cash.

You can abbreviate earnings yield to EBIT/EV.

This gives you the earnings yield for the whole business expressed as an interest rate. Generally speaking, the higher the interest rate, the cheaper the share.

The earnings yield gives you a lot of information:

  • It tells you what you’re paying for the assets of a business, which it finances with equity and borrowings (EV).
  • And it tells you the profits that these assets produce (EBIT).

The advantages of using the earnings yield over the PE ratio

This ratio gives you an advantage over using the price earnings (PE) ratio. The PE ratio only focuses on equity. This can lead you to make mistakes and buy the wrong share or end up paying the wrong price.

This is because debt can make shares look cheaper when you use the PE ratio. So you might end up thinking a share is cheaper than it really is.

Another advantage of using the earnings yield is it gives you an easy way to compare the valuations of different companies that may have different financing structures.

Different tax rates don’t have an impact on earnings yield, whereas they do with PE ratios.

But don’t use earnings yield to look into financial companies like banks and insurance companies. It’s not the best valuation measure you can use for this sector.

So there you have it. Why you should have a look at a company’s earning yield when deciding to invest.

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