Investors sometimes become too mechanical in their selection of stocks and do not really consider what they are actually looking at. We attempt to mechanize our process and may decide, as an example, that we want to screen our stocks to omit those with a return on equity of less than 15. While that is a great number, it also excludes stocks that have ROE’s of 14 that may actually be a better selection.
Benjamin Graham advocated finding stocks that have an earnings yield that are at least twice the AAA bond rate. The earnings yield is an easy find and all investors should look at it; however, they should also realize exactly what they are looking at. If stock ABC has earnings for the last 12 months of .75 and is currently selling for $10.00, the earnings yield would be 7.5%. (0.75/10.00). This number is then measured against the current AAA bond rate (say 5%) to determine whether the extra 2 ½% return compensates the investor for the risk taken. In this example, we can see that the earnings yield is not twice the bond rate; therefore, we may choose to exclude it for now.
Recognize that other value investors do not use the requirement for “twice the AAA bond rate.” Bonds are typically at a fixed rate. Therefore, some value investors will decidedly pick a stock that has an earnings yield greater than the bond rate with the knowledge that the stock also has an earnings growth rate of 10% (as an example). You not only have the extra 2½% as our example shows, but it also will be growing at 10%. This may or may not satisfy you for the risk involved.
Also realize that there are other methods for determining earnings yield. For instance, Joel Greenblatt’s method for determining earnings yield is different than what is typically used. Basically, EBIT/Enterprise value, but I won’t explain the entire difference here. Always remember to know exactly what you are looking at.
What happens for instance if you use diluted earnings? While diluted earnings are supposed to provide you with a truer number, understand that will skew the earnings yield. For instance, you may find stocks that have diluted earnings less than reported earnings, but you may also have diluted earnings greater than the reported earnings. The important message here is to know what you are looking at. An example:
Reported Eps = $2.00
Current Price = $22.00 (2.00/22.00 = 9% earnings yield)
Reported Eps = $2.00
Diluted Eps = $2.20
Current Price = $22.00 (2.20/22.00 = 10% earnings yield)
Report Eps = 2.00
Diluted Eps = 1.80
Current Price = $22.00 (1.80/22.00 = 8.1% earnings yield)
When it comes to yields, I like to take a step further. I also want to see the cash return. Because cash is king, I find this metric more useful and is simply found by dividing free cash flow by the enterprise value. The enterprise value is the market capitalization plus debt and minus cash and is typically published on most websites.
If I apply this to Intel (INTC, Financial), the enterprise value is shown to be $128,650 million and the free cash flow is shown to be $11,485 million. Therefore, 11485/128,650 = 8.9%. I compare this number with the AAA bond rate in addition to looking at the earnings yield. Intel currently shows earnings (ttm) of $2.24 and is selling for $23.64. Therefore, the earnings yield is 2.24/23.64 = 9.4%.
The two easy yield metrics are useful in comparing companies.
Costco (CSCO, Financial):
Earnings Yield = 3.19/82.31 = 3.8%
Cash Return = 1787/33426 = 5.3%
Walmart (WMT, Financial):
Earnings Yield = 4.50/56.06 = 8%
Cash Return = 11433/247403 = 4.6%
Target (TGT, Financial):
Earnings Yield = 4.03/50.34 = 8%
Cash Return = 3211/51444 = 6.2%
Now you have two yields that you can use. In this example, Target has the two better numbers.
The bottom line to this exercise is to know what you are looking at and don’t necessarily settle for the first yield or metric that gives you the answer you were hoping to find.
Benjamin Graham advocated finding stocks that have an earnings yield that are at least twice the AAA bond rate. The earnings yield is an easy find and all investors should look at it; however, they should also realize exactly what they are looking at. If stock ABC has earnings for the last 12 months of .75 and is currently selling for $10.00, the earnings yield would be 7.5%. (0.75/10.00). This number is then measured against the current AAA bond rate (say 5%) to determine whether the extra 2 ½% return compensates the investor for the risk taken. In this example, we can see that the earnings yield is not twice the bond rate; therefore, we may choose to exclude it for now.
Recognize that other value investors do not use the requirement for “twice the AAA bond rate.” Bonds are typically at a fixed rate. Therefore, some value investors will decidedly pick a stock that has an earnings yield greater than the bond rate with the knowledge that the stock also has an earnings growth rate of 10% (as an example). You not only have the extra 2½% as our example shows, but it also will be growing at 10%. This may or may not satisfy you for the risk involved.
Also realize that there are other methods for determining earnings yield. For instance, Joel Greenblatt’s method for determining earnings yield is different than what is typically used. Basically, EBIT/Enterprise value, but I won’t explain the entire difference here. Always remember to know exactly what you are looking at.
What happens for instance if you use diluted earnings? While diluted earnings are supposed to provide you with a truer number, understand that will skew the earnings yield. For instance, you may find stocks that have diluted earnings less than reported earnings, but you may also have diluted earnings greater than the reported earnings. The important message here is to know what you are looking at. An example:
Reported Eps = $2.00
Current Price = $22.00 (2.00/22.00 = 9% earnings yield)
Reported Eps = $2.00
Diluted Eps = $2.20
Current Price = $22.00 (2.20/22.00 = 10% earnings yield)
Report Eps = 2.00
Diluted Eps = 1.80
Current Price = $22.00 (1.80/22.00 = 8.1% earnings yield)
When it comes to yields, I like to take a step further. I also want to see the cash return. Because cash is king, I find this metric more useful and is simply found by dividing free cash flow by the enterprise value. The enterprise value is the market capitalization plus debt and minus cash and is typically published on most websites.
If I apply this to Intel (INTC, Financial), the enterprise value is shown to be $128,650 million and the free cash flow is shown to be $11,485 million. Therefore, 11485/128,650 = 8.9%. I compare this number with the AAA bond rate in addition to looking at the earnings yield. Intel currently shows earnings (ttm) of $2.24 and is selling for $23.64. Therefore, the earnings yield is 2.24/23.64 = 9.4%.
The two easy yield metrics are useful in comparing companies.
Company | Current Price | Eps (ttm) | FCF | E/V |
Costco (Cost) | 82.31 | 3.19 | 1,787 | 33,426 |
Walmart (Wmt) | 56.06 | 4.50 | 11,433 | 247,403 |
Target (Tgt) | 50.34 | 4.03 | 3,211 | 51,444 |
Costco (CSCO, Financial):
Earnings Yield = 3.19/82.31 = 3.8%
Cash Return = 1787/33426 = 5.3%
Walmart (WMT, Financial):
Earnings Yield = 4.50/56.06 = 8%
Cash Return = 11433/247403 = 4.6%
Target (TGT, Financial):
Earnings Yield = 4.03/50.34 = 8%
Cash Return = 3211/51444 = 6.2%
Now you have two yields that you can use. In this example, Target has the two better numbers.
The bottom line to this exercise is to know what you are looking at and don’t necessarily settle for the first yield or metric that gives you the answer you were hoping to find.
