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P/E Ratio and Earnings Yield

As you probably know, A Company's P/E ratio is equal to a its share price divided by its earnings per share. However, as a value investor, you should look at this metric from a different perspective.

It is useful to look at a metric known as the Earnings Yield. This is equal to the company's earnings per share divided by its share price; it is also equal to 100 divided by a company's P/E ratio. If Jack's lemonade stand is trading at 20 times earnings it's earnings yield is 100 divided by 20, which is 5%.

In our Return on Equity article, we noted that a company's earnings per share is a rough estimate of the amount of cash a company will earn in a year if it is not growing (i.e. if the company is not spending money in order to expand its business). So, suppose the Jack Company is not expanding its business and has an earnings yield of 5%. The company can pay all of its earnings as dividends; thus, the company can pay a 5% dividend yield. So you'd expect that an investor in the Jack Company's stock would earn a 5% annual return.

But there's something else: the Jack company earns a return on capital of 20%. If Jack can use all his income to expand his business, earnings per share will grow at 20% per year, and if earnings grow at 20% forever, shareholders will earn a 20% annual return. Thus, we can expect that Jack Company stock will return between 5% and 20% per year; If the company grows rapidly and can maintain that growth for a long period of time, the return will be closer to 20%, while if the Jack Company finds few opportunities to expand its business, the return will be closer to 5%.

The important point here is that the annual return of a solid business will generally be somewhere between its earnings yield and its return on equity.