Earnings Yield Tutorial

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Introduction

The Earnings Yield is the earnings per share divided by the current share-price. Assuming those earnings were to continue into the future and would be paid out as dividends, the earnings yield can be used to quickly assess whether the stock is cheap or expensive, e.g. by comparing the earnings yield to low-risk government bonds and expected stock-market returns over the long-term.

In this tutorial we use the company Lululemon as an example. You can view the full simulation report here. We do not have any special insights into this company, so we merely use historical data to estimate the probability distributions for the inputs. We will not update this tutorial with new data in the future.

Simulate Earnings Yield

The earnings yield is typically calculated from the current earnings per share divided by the current share-price. But this may be very misleading if the current earnings are abnormally high or low. That is why we simulate the earnings using probability distributions for the sales and profit margin, so we can see the entire range of likely earnings yields.

The first plot below shows a histogram with the earnings yield on the x-axis, where higher vertical bars means there were more simulation results for those values. The full range of earnings yields is between 2% and 5.7%. Considering that US government bonds currently yield around 5%, it either means that the company's future earnings are less risky than US government bonds, or that the future earnings will have to grow. Otherwise an investor would get a higher and more certain return from US government bonds.

We can add a growth-rate to the earnings yield, which assumes the future earnings grow and compound by that rate every single year. In this case the average earnings yield is 3.9%, so the future earnings would have to grow around 1.1% every single year to give an average return of 5% as we can get from government bonds. If we want the same average return of 9% as the historical long-term return on the S&P 500, then the company's future earnings would have to grow around 5.1% every year. So at the current price-level of this stock, the company must grow its future earnings, otherwise we would be better off investing in either government bonds or a stock-market index.

The second plot below varies the current share-price on the x-axis and shows the earnings yield on the y-axis. The histogram above is actually the slice shown as the vertical dashed blue line. The light-blue colors show low occurrences of simulated earnings yields, while darker blues show increasingly higher occurrences of simulated earnings yields. This plot lets us easily see how the earnings yield changes with the current share-price.

You can view the full report and clone the simulation to run it yourself with different input values.

Simulate Price Change

This model also simulates the changes in share-price by multiplying the sales and P/S ratios. We again use historical input data for this. The results are shown in the plot below, where the simulated share-price change is between -75% and +250%. So if the future P/S ratio will be similar to the historical values, then the share-price would likely increase significantly.

But is this a reasonable assumption? Remember that the earnings yield is already lower than US government bond yields, so if the future share-price is even higher, then the future earnings yield would be even lower, and hence require even more earnings growth, in order for the earnings yield to merely match the government bond yield.

Just because people have paid high valuation ratios in the past, does not mean people will also do that in the future, especially if the company will no longer grow as much as it did in the past. So it would be optimistic to assume the high valuation ratios from the past will also continue in the future. A cautious long-term investor should generally focus more on the earnings yield than the price change.

The second plot below varies the current share-price on the x-axis and shows the simulated price change on the y-axis. The histogram above is actually the slice shown as the vertical dashed blue line. This plot lets us easily see how the current share-price affects the simulated change in share-prices.

You can view the full report and clone the simulation to run it yourself with different input values.