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Tuesday, December 22, 1998

An Investment Opinion
by Warren Gump

Earnings Yield: A Tool for Investors

Numerous methodologies have been presented for individual investors to gauge the value of companies. One of the more prevalent is the price/earnings (P/E) ratio relative to the company's long-term growth rate, a.k.a. the PEG ratio. This ratio can be extremely valuable for investors as a guide to how much they're paying for a company. Another way to think about what you're paying for a company is to calculate the earnings yield, or the inverse of the P/E ratio.

If you are confused about the different ratios discussed above, there is a quick example calculating the value of them for Clorox Co. (NYSE: CLX) at the bottom of this article. Also included in this list is the yield on the 30-year Treasury bond. Whoa there! What's that Treasury bond yield doing here? Aren't we talking about stocks? We are, but the value of stocks is related to that of bonds.

When you have a dollar to invest, you can choose many different alternatives, whether it be stocks, bonds, or Beanie Babies. Treasury bonds have a fixed cash flow payout, based on interest payments and the payment of principal at maturity. Since they are issued by the federal government, which literally has the ability to print money, the risk of not receiving this cash flow is considered minimal. Almost everyone considers them to be "risk-free" securities.

Stocks aren't as predictable as Treasury bonds. There is no definitive payout. In fact, many companies try to minimize (or not pay) a dividend so that their earnings can be reinvested to help the company grow in the future. Because the dividend payout depends on how a management team decides to allocate capital, it is usually not a good measure for determining overall return. This is where the earnings yield comes in. It gives you thumbnail sketch of the current return the company is earning on your investment.

How can this be used in practice? Clorox has a current earnings yield of 2.7% while the 30-year Treasury bond yields 5.1%. At face value, that doesn't make a whole lot of sense. The "risk-free" bond has a higher yield than a stock that doesn't provide any guaranteed return. What gives? It's the key to what makes investing profitable over time: growth.

Assuming that the 13% consensus annual growth rate furnished by First Call is accurate, let's see what happens to Clorox's reported earnings per share and earnings yield (based on yesterday's closing price).

Year       1998   2003    2008     2018     2028
Earnings $3.00 $5.53 $10.18 $34.57 $101.70
E. Yield 2.7% 4.9% 9.0% 30.5% 89.8%

I like to see how long it takes the earnings yield to pass through that of the Treasury bond. In the case of Clorox, it would take six years, to 2004, before the earnings yield tops 5.1%. I also like to find out when the earnings yield passes an acceptable return for taking on the uncertainty associated with owning stocks. This return is calculated by tacking a "risk premium" onto the Treasury bond yield. Adding an arbitrary 5 percentage point risk premium to the 5.1% Treasury bond yield results in a targeted equity yield of 10.1%.

Clorox's earnings yield, using the forecasted growth rate, would pass this benchmark in 2009. Earnings would exceed the return I seek eleven years from now. That's a pretty long time, even if the potential prospects beyond 2009 look appealing. When doing this analysis, you are assuming that the company is able to pump out the projected earnings growth. While that seems plausible based on the company's history, it is by no means a certainty. There are many potential events that could interrupt this earnings growth.

Returns earned by shareholders, of course, are not equal to an earnings yield. Shareholders only receive dividends paid by the company plus the difference between the original stock purchase price and the ultimate sales price. The former number is known, while the latter will not be determined until the shareholder decides to sell. Overall, changes in earnings are fairly well correlated with movements in stock prices.

When investors become enamored with an investment theme, however, a company's earnings can fall but its stock price increases. The opposite can also be true. If a company goes out of favor with investors, the company can increase earnings but see its stock price tumble. Instead of being subject to such market vagaries, the earnings yield provides an indication of the return you would be earning if you were the outright owner of the company.

I don't have a magic formula to trigger buy and sell decisions based on earnings yields. Rather, it is a tool to add to your arsenal to provide an indication of what a company is earning on your investment. For similar growth companies, I would prefer the one with a higher earnings yield and a shorter "passthrough" time to hit my desired equity returns. Before making comparisons, however, be sure that the prospects for the companies being compared are equal. Predicting the future can be really tricky. At the end of 1993, analysts were expecting great things from both Boston Market and America Online (NYSE: AOL). Five years later, Boston Market has filed for bankruptcy (after seeing earnings vaporize into losses) while America Online has soared from less than $2 to over $120 as earnings exploded.

Use of traditional valuation metrics such as cash flow multiples, earnings multiples, and price/book ratios has not resulted in the sexiest investment returns over the past few years. Most investors using these methodologies have severely underperformed the S&P 500 index. It has been much more profitable to almost blindly invest in the largest companies or "story stocks," those that sound neat and appear to hold great promise of future growth.

Given these recent results, a good number of investors have determined that valuation doesn't matter in stock investing any more. You just buy and hold stocks that have done well and prices will continue to increase regardless of underlying fundamentals. Perhaps they're right. I have to admit, though, that I still like to base my investing decisions on the amount of current and future earnings I'm purchasing for a buck.

Clorox Statistics:
Price: $113 5/16 (12/21 closing price)
Earnings: $3.00 (First Call calendar 1998 estimate)
Growth Rate: 13% (First Call consensus)

Ratios & Yields:
Price/Earnings (P/E) Ratio: 37.8 ($113.31/$3.00)
Price/Earnings-to-Growth (PEG) Ratio: 2.9 (37.8/13)
Earnings Yield: 2.7% ($3.00/$113.31)

30-year Treasury bond yield: 5.1% (12/21 Closing yield)

(Author's Note: in this article, I refer repeatedly to earnings. In actually valuing companies, it is much more important to look at cash flows. This article assumes that earnings approximate cash flows, which is often, but not always true. If you want to learn a little more about Clorox, here is a link to an overview published on Friday.)

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