What is Earnings Yield?

Earnings yield flips the P/E ratio to express valuation as a percentage return. A stock with a P/E of 20 has an earnings yield of 5% (1/20). This format makes it easy to compare stocks with bonds — if the 10-year Treasury yields 4% and a stock has an earnings yield of 7%, the stock offers a 3% premium for bearing equity risk.

The earnings yield is a key component of the Fed Model, which compares the S&P 500 earnings yield to the 10-year Treasury yield. When the earnings yield significantly exceeds the bond yield, stocks are considered relatively attractive, and vice versa. While the Fed Model has its critics, the earnings yield remains a useful framework for thinking about equity valuations in the context of interest rates.

Joel Greenblatt's Magic Formula uses earnings yield (specifically EBIT/EV) as one of two factors for stock selection. His research showed that buying high-earnings-yield, high-return-on-capital companies systematically outperformed the market over long periods.

Forward earnings yield, based on expected future earnings, is generally more useful than trailing earnings yield. In a rising interest rate environment, investors demand higher earnings yields (lower P/E ratios) to compensate for the increased opportunity cost of holding stocks versus bonds.