Earnings Yield

Earnings yield is the inverse of the price-to-earnings ratio, calculated as Earnings Per Share ÷ Price Per Share (or equivalently, 1 ÷ P/E ratio). It expresses a company's earnings as a percentage of its stock price, making it directly comparable to bond yields and interest rates. A stock with a P/E of 20 has an earnings yield of 5% (1/20 = 0.05), meaning investors are "earning" 5% on their investment in the form of corporate profits.

Earnings yield is valuable because it bridges the gap between equity and fixed-income analysis. When a stock's earnings yield exceeds the 10-year Treasury yield, equities are theoretically more attractive than bonds (assuming earnings are sustainable and growing). This comparison, known as the Fed Model, was popular in the 1990s and early 2000s. While the Fed Model has limitations (bond coupons are guaranteed while earnings are not, and earnings grow while bond coupons don't), the earnings yield framework remains useful for understanding relative attractiveness.

Joel Greenblatt popularized earnings yield in his "Magic Formula" investing approach, where he uses EBIT/Enterprise Value (a variation of earnings yield that accounts for debt) as one of two ranking factors. This approach has shown strong long-term performance in backtests. For practical use, earnings yield helps investors quickly compare valuations: a stock with a 7% earnings yield (P/E of ~14) offers more earnings per dollar invested than one with a 3% yield (P/E of ~33). During periods of high interest rates, earnings yields must be higher to compete with risk-free alternatives, which is why P/E ratios tend to compress when rates rise.