Two Good Ways to Measure Value and Safety
Investors have used P/E ratios as a way to measure the value of stocks, but an interesting alternative is to think of "earnings yield" instead. What is earnings yield? It's the P/E ratio measured in the opposite way. For example: if a stock is trading at 12 times earnings, it has an earnings yield of 1/12, or 8.33%.
Looking closely at earnings yield is the first step toward measuring value, because it allows you to make a quick and simple comparison between stocks and bonds - which will help to keep you from ever paying too much for a stock.
Here's how to do it: Suppose you checked Moody's and found a ten-year corporate bond (rated Aaa) yielding 7%. That is what's good about bonds - you know how much you'll make. But with stocks, earnings will fluctuate, but you can nevertheless approximate the same kind of yield from equities.
So you can figure a company's earnings yield by merely inverting its P/E ratio. Thus, a P/E of 5 results in an Earnings Yield of 20.0%; a P/E of 8 results in an Earnings Yield of 12.5%, etc..
Therefore, relating what we have just stated to the S&P 500, we see via the latest edition of Barron's (February 20, 2006) that the S&P 500 currently has a P/E ratio of 18, giving us a yield of 1/18, or 5.56%. Therefore in today's market, since stocks are only earning 5.56%, with lots of risk, the advantage in this hypothetical situation is clearly in favor of the bond.
And now some thoughts on Safety. One good way to measure safety is by figuring out if the company you are looking at can afford to buy itself. Ask yourself this question: Are the balance sheet assets and the cash flow of the company strong enough to accept new debt equal to the current market cap?
Whenever a company has a strong enough balance sheet and a strong enough business to buy back all of its stock - at least on paper - you then have a large margin of safety, which essentially gives you the same risk as a bondholder, and that in turn makes your greater earnings yield that much more attractive. You're only taking the risks of debt holder, while you will receive the return of an owner.
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Looking closely at earnings yield is the first step toward measuring value, because it allows you to make a quick and simple comparison between stocks and bonds - which will help to keep you from ever paying too much for a stock.
Here's how to do it: Suppose you checked Moody's and found a ten-year corporate bond (rated Aaa) yielding 7%. That is what's good about bonds - you know how much you'll make. But with stocks, earnings will fluctuate, but you can nevertheless approximate the same kind of yield from equities.
So you can figure a company's earnings yield by merely inverting its P/E ratio. Thus, a P/E of 5 results in an Earnings Yield of 20.0%; a P/E of 8 results in an Earnings Yield of 12.5%, etc..
Therefore, relating what we have just stated to the S&P 500, we see via the latest edition of Barron's (February 20, 2006) that the S&P 500 currently has a P/E ratio of 18, giving us a yield of 1/18, or 5.56%. Therefore in today's market, since stocks are only earning 5.56%, with lots of risk, the advantage in this hypothetical situation is clearly in favor of the bond.
And now some thoughts on Safety. One good way to measure safety is by figuring out if the company you are looking at can afford to buy itself. Ask yourself this question: Are the balance sheet assets and the cash flow of the company strong enough to accept new debt equal to the current market cap?
Whenever a company has a strong enough balance sheet and a strong enough business to buy back all of its stock - at least on paper - you then have a large margin of safety, which essentially gives you the same risk as a bondholder, and that in turn makes your greater earnings yield that much more attractive. You're only taking the risks of debt holder, while you will receive the return of an owner.
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posted by Bob Moser at
3:28 PM
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