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One Useful Way to Look at a Company’s Earnings

The Price-Earnings ratio of a share is a widely used metric in the determination of its intrinsic value. It has a simple mathematical formula – price per share divided by earnings per share – and is usually taken as a proxy for the market’s future expectation of the company.

But despite the ubiquity of the PE ratio, its inverse, the earnings yield, is not so commonly seen. That’s unfortunate because the earnings yield can be a powerful way to help frame an investor’s thinking toward investing in the right shares.

What’s an equity coupon?

For memory’s sake, here’s a refresher on how the earnings yield is calculated:

Earnings Yield = Earnings Per Share / Price Per Share

To reiterate again, the earnings yield is the exact opposite of the PE ratio.

Now, the powerful thing about looking at the earnings yield is this; it can essentially be seen as an ‘equity coupon’ in much the same way that fixed-income investors look at their bond coupon rates. For a simple example, a share with a PE of 20 will have an equity coupon of 5% (earnings yield = equity coupon = inverse of the PE = 5%)

And here’s the trick. When you invest in a company at a certain PE ratio, you’ve locked yourself to an initial equity coupon. But over time, as the business evolves, the equity coupon relative to your initial cost would have changed.

How an equity coupon analysis works

If a business is able to grow its earnings over time, the equity coupon that an investor is entitled to, would have increased. Conversely, a share whose earnings decreased would mean a declining equity coupon for the investor.

In the first situation, that’s almost akin to having a bond that increases its interest payments over time! Meanwhile, the reverse is true for the second situation, where investors can liken their investments to a bond that pays out smaller interest over time.

Here’s how it works out, using five different shares as examples:

11 Oct 2007

26 July 2013
*Price, S$ *TTM EPS, S$ TTM PE Initial Equity Coupon *TTM EPS, S$ Equity Coupon Relative to Cost
Super Group (SGX: S10) 0.88 0.057 15.5 6.5% 0.15 17.0%
Vicom (SGX: V01) 1.78 0.16 11.2 8.9% 0.31 17.1%
Dairy Farm Holdings (SGX: D01) 5.10 0.17 30.4 3.3% 0.33 6.5%
Singapore Airlines
(SGX: C6L)
20.20 1.58 12.8 7.8% 0.36 1.8%
Singapore Exchange (SGX: S68) 15.80 0.47 33.3 3.0% 0.31 2.0%
*Monetary figures for Dairy Farm are in US$. TTM = Trailing-12-months

The first three, Super Group, Vicom, and Dairy Farm, are examples of shares that give investors a growing equity coupon. The other two, SIA, and SGX, are shares that have a declining equity coupon.

Assessing returns with the equity coupon

So what the earnings yield gives investors is, the ability to easily see the benefits of buying shares that can grow its earnings as opposed to those with declining earnings. The former gives investors a larger equity coupon over time, while the former has only a shrinking coupon to show for its efforts.

The difference in how the equity coupons change eventually translates into share price performance. From 11 Oct 2007 to 25 July 2013, we see Super Group, Vicom and Dairy Farm’s shares growing by 440%, 166% and 134% respectively. Meanwhile, SIA and SGX have both declined by almost half.

With the earnings yield, it becomes easier for investors to actually frame the investment in terms of the returns they are getting when they’re paying X amount of dollars for each dollar of earnings for a share in relation to its business prospects.

Assessing risks with the equity coupon

Besides assessing returns, the equity coupon also makes it easy for investors to compare the riskiness of a share’s valuation (in terms of the PE ratio) in relation to a ‘risk-free’ asset such as a Singapore government bond.

As of 25 July 2013, the 10-year Singapore government bond (under the issue code NX13100H) is yielding 2.5%. For a share like Super Group, with a current equity coupon of 3.2% (based on a share price of $4.75 and TTM EPS of $0.15), it would seem that it’s more attractive than the government bond given its higher equity coupon.

But, investors must remember that companies carry much more financial risk than a sovereign nation like Singapore and thus, a coupon-difference (or spread) of 0.7 percentage points might not be adequate compensation for the additional risk that investors undertake when choosing Super Group over the Singapore government’s 10-year bond.

On the other hand, there’s always a chance that Super Group can grow its equity coupon over time, with the prospect for growth overwhelming the inadequate risk-compensation – as exemplified by the small spread between its coupon and that of the 10-year bond.

Foolish Bottom Line

Ultimately, using the earnings yield gives investors a useful tool to measure the returns they’re getting in terms of earnings and the relative attractiveness of a share in relation to a risk-free asset after careful consideration of its future business prospects.

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