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In the last couple of posts we discussed some of the basics of the PE ratio.  However, an often more meaningful measurement is obtained by, literally, flipping the P/E ratio upside down.

Earnings Yield

While the P/E ratio helps us understand the price of a stock relative to its earnings, the earnings yield gives us more of a “yield” or percentage return metric.  Let’s use our prior example of Friend A from our PE ratio explained part II post.

Friend A’s company has earnings of $5 per share, and he is selling shares to investors for $10 per share.  Let’s say he realizes that, given the prospects for growing his business, $10 per share is way too cheap to be offering shares.  So, he starts selling shares for $100 per share.  His earnings yield is simply the result of dividing Earnings Per Share by Price Per Share and expressing as a percentage:

Earnings Yield ( % ) = ($5 per share / $100 per share) X 100 = 5%

We’ll see in our next post that this metric is particularly useful for comparing different types of investments.

Tags: earnings yield, pe ratio, Stock Metrics

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In our prior post (The P/E Ratio Explained Part I) we discussed the various methods of calculating the P/E ratio.  However, what does it mean conceptually?  Essentially, the P/E should tell you how expensive a stock is based on the earnings of the company.

An Example

Let’s say you are presented with 2 choices.  You have 2 friends that have businesses making running shoes.  They have both been in business about 5 years, and both businesses make $1,000 in profit per year (ok, so they are really small businesses).  In addition, both businesses are offering to sell shares of the business to their friends.  Friend A is selling 200 shares for $10 a share, and Friend B is selling 500 shares for $5 a share.  Which is really a better deal?  Let’s keep it basic and not consider the concept of present value for now.

Friend A is selling 200 shares, so let’s figure his earnings per share (EPS).  We do this by simply dividing earnings (this is the profit of $1,000 per year) by 200 shares = $1,000 / 200 = $5 per share.  So, the P/E is:

P/E = $10 per share / $5 per share = 2.0

How about friend B?  We do the same thing - Friend B is selling 500 shares so the earnings per share (EPS) = $1,000 / 500 = $2 per share and the P/E is:

P/E = $5 per share / $2 per share =2.5

So this tells us (in theory) that Friend A’s offer is slightly better - since investors pay less for a share of stock relative to future earnings.

Tags: pe ratio, price to earnings

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Barron’s posted an excellent article this weekend on why the wall street bailout is a good thing (subscription may be required) for the government and taxpayers.  Why?  The markets & public have assumed that the mortgage-backed securities the government will purchase are far worse than they actually are.  In fact, most are senior “tranches” of loan portfolios (higher quality & lower risk), which means less senior slices will absorb any losses first.  Even assuming very high rates of default and low foreclosure recovery rates for these loan portfolios, the government could very possibly enjoy a 7-8% return on their investment!

Further, the bailout will help free up capital in the credit markets, boost prices of mortgage-backed securities to a level reflecting reality, and (most importantly) stop the continued decline in housing prices.

Related Links

Barrons.com

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Much has been made of the disaster surrounding subprime lending and the subsequent government bailouts of large institutions such as AIG.  The media has done an adequate job of scaring the masses to death, and many will do (as is human nature) the wrong thing and exit the markets licking their wounds.

However, if you can, stay the course and tune out the media.  Why?  History has shown that the government has always stepped in to correct large scale financial problems.  Don’t believe me?  Give this Wall Street Journal article on government bailouts a quick read (may require subscription).

The bottom line: the US continues to be a premier player in the world economy.  Markets boom and bust (and will continue to do so) but as a significant world power we are relatively young.  Sure, things will be a little tougher for a while - but keep your eyes on the horizon as US stocks are still the place to be in the long run.

Tags: government bailouts, stock market

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While it’s no surprise that unemployment continues to plague the US economy - we certainly don’t need more data to confirm the situation.  However, in this market even bad news that’s as bad as analysts expect (and not worse) could be good news.  That might just be the case with US unemployment data just released this morning.

July nonfarm payrolls fell by 51,000 and the rate of unemployment grew slightly to 5.7% (vs. 5.5% in June).  While this is the highest rate in 4 years, at least it wasn’t as bad as the market was expecting - Dow futures are up ahead of the market open.  Hey, I’m trying to look on the bright side of things here.

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