Earnings Yield is defined as
Earnings Yield = EBIT / Enterprise Value EBIT = Earnings Before Interest and Taxes. Enterprise Value = Market Value of Equity + Net Interest Bearing Debt
Let us understand this with an example. Imagine you purchased a building with the following terms.
Purchase price = $100 Mortgage = $ 80 Equity = $ 20 Enterprise Value = Mortgage + Equity Enterprise Value = $100
If the building generates $10 per annum before interest and taxes then
EBIT = $10 Earnings Yield = EBIT / Enterprise Value Earnings Yield = $10 / $100 Earnings Yield = 10%
Why is this important?
It helps us to measure the return generated by an asset. All else being equal, assets generating higher earnings yield is better than the one generating lower yield.
How is this different from E/P?
Most of us will know about the famous P/E ratio.
Price of a stock = $10 Earnings Per Share = $1 P/E = $10 / $1 = 10
E/P is an inverse of P/E.
Earnings Per Share = $1 Price of a stock = $10 E/P = $1 / $10 E/P = 10%
E/P is much simpler. Then why not use this? In the book The Little Book That Still Beats the Market – Joel-Greenblatt gives the following problem to explain the difference
Consider two companies, Company A and Company B. They are actually the same company (i.e., the same sales, the same operating earnings, the same everything) except that Company A has no debt and Company B has $50 in debt (at a 10 percent interest rate). All information is per share. The price of Company A is $60 per share. The price of Company B is $10 per share. Which is cheaper?
Company A Company B Sales $100 $100 EBIT $10 $10 Interest exp. $0 $5 Pre-tax income $10 $5 Taxes (@40%) $4 $2 Net income $6 $3
Try to solve the problem without looking at the answer. Just by reaching, your learning will be much deeper even if you did not solve it.
P/E of company A is $60 / $6 = 10 P/E of company B is $10 / $3 = 3.33 Earnings Yield of company A is $6 / $60 = 10% Earnings Yield of company B is $3 / $10 = 30%
Using E/P we can conclude that company B is cheaper. Not so fast. If all you know is E/P then you are a Man with a Hammer. Let us solve the problem using the original formula.
Company A Company B Enterprise value(price + debt) 60 + 0 = $60 10 + 50 = $60 EBIT 10 10 Earnings Yield 10 / 60 = 16.67 10 / 60 = 16.67
They are the same. Excerpt from the book
To a buyer of the whole company, would it matter whether you paid $10 per share for the company and owed another $50 per share or you paid $60 and owed nothing? It is the same thing! You would be buying $10 worth of EBIT for $60, either way!