How to calculate intrinsic value - Earning Yield


What Is Earning Yield?


In layman's terms, earning yield,  tells you, “If this stock were a bond, how much would it earn as a percentage of my investment based on this year’s after-tax profits?” Earning Yield is the inverse of P/E ratio.
  • Earning Yield =  Net Income ÷ Purchase Price
  • Earning Yield =  1 ÷ P/E ratio of stock

How to Calculate Earning Yield?
Earning Yield can be calculated, one of two ways:

Imagine you bought a regional movie theater company for $20 million that earned $2 million in net income.  In this case, the earnings yield would be 10% ($2 million net income divided by $20 million purchase price = 10% earnings yield).  Alternatively, imagine that you were looking at shares of an social media company trading at $25 with a p/e ratio of 8.  The earnings yield would be 12.5% (1 divided by 8 p/e ratio = 12.5% earnings yield).

Alternative Way to Calculate Earning Yield

Joel Greenblatt, the creator of perhaps the two most practical investment books, ( The Little Book That beats the Market, and You Can Be a Stock Market Genius) introduced an alternative way to get Earning Yield.

Modified Earning Yield = Operating Earning / Enterprise Value.

Personally I prefer this way to view earning yield as it takes away the business capital structure, allowing you to more accurately compare between two or more businesses outside of the same industry ( which is what we want).
The Short Comings of Using Earning Yield as a Valuation Tool 

Personally I don’t like to factor in growth in my valuations. When you start trying to measure growth you start getting into the business of guessing.  The more you guess the more risk you take in being ” All the way wrong then somewhat right”.
We measure our investments by looking through multiple scenarios ( good, bad, the ugly) and go from there. Some of you may be thinking, ” isn’t that guessing as well?” and while yes, this practice is technically guessing, it is doing so based on the facts of the business.

Closing

Earning Yield, while a great tool to use to compare businesses to each other in the past ( last 12 months) it doesn’t take into account potential growth. Buying stocks based on past earning yields, is fine, buying stocks based on what you think the earning yield will be next year is great ( in many people's eyes) If I do not value a business using different scenarios there is a major risk that I would use the following process: Gather Evidence > Explain Evidence with a Story > Match Decision to Story Predicting an upside, central case and downside scenario for a business, and attaching probabilities to each of these scenarios, is likely to prevent me from coming up with a story about whether I should buy the business. This is because I am forcing myself to predict more than one future for the business. If the earning yield of the ” ugly” scenario isn’t higher then my required rate of return, then I move on.
If used in the right context, earning yield can be a great tool to use when valuing a business. Its versatility allows it to be used not just with the stock market, but also when trying to buy any cash generating asset(s). ( for example a website or lawn business) If the asset doesn’t yield far more than the 10 year US treasury bond then its not an investment worth looking into.

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