A Deeper Look at the Price-To-Earnings Ratio: Part 3

Previously, we learnt that a cheap company today may not be a cheap company 10 years from now and that there are different variants to the price-to-earnings (PE) ratio.

Today, let us first look at one ratio that is often overlooked – the earnings yield. Earnings yield is the inverse of the PE Ratio. The PE ratio is calculated by dividing the market price of a stock by its earnings per share. Say Company A has a PE ratio of 10. This means it theoretically takes 10 years before the company makes sufficient earnings to justify its share price today. The earnings yield would be 10% (obtained by (1/10)*100%).

The earnings yield essentially shows the company’s earnings return per annum on the share price. Buying Company A’s share today is equivalent to earning 10% on the stock on an annual basis. What this ratio does is it enables us to compare apples with apples between different asset classes.

As an investor, we usually have to decide whether to invest our money in various asset classes such as shares, commodities and bonds. Alternatively, perhaps we may choose to keep it in the bank instead if we are risk-averse. So Company A essentially offers an equivalent of 10% return on your investment. We know this is not as certain as putting your money in a Singapore Savings Bonds (SSB) that is guaranteed by the Singapore Government for slightly over 2% p.a. for a 10-year holding period.

Still, if we have an insanely high PE ratio of 40, which is equivalent to an earnings yield of 2.5% today, would you decide to undertake the risk and buy Company A or would you rather put your money in a SSB? In economics and finance alike, the most important concept beyond compound interest is the opportunity cost. There are inherent limitations in comparing asset classes, but earnings yield can help bridge that gap.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.