The importance of financial parameters in making prudent investing decision is undeniable. When you are not able to decide whether to invest in stocks or bonds, you can take the help of some key financial metrics. One such metric, which assists investors in making correct decisions, is earnings yield. It is the reciprocal of the price-to-earnings (P/E) ratio. In fact, this ratio is very useful for tracking undervalued stocks. It also comes in handy for comparing stocks with the market or fixed income securities.
Earnings yield can be computed as (Annual Earnings per Share/Market Price) x 100. This is used for comparing stocks from the same sector or industry. The stock with higher earnings yield is likely to produce better returns.
For the purpose of comparing the performance of a market index with the 10-year Treasury yield, this ratio is also very useful. When the yield of the market index is higher than the 10-year Treasury yield, the stocks can be considered as undervalued in comparison to bonds. This gives an indication that investing in the stock market is a better option for a value investor.
Investment in Treasury-bill is not fraught with risks. However, investing in stocks always comes with a caveat. Hence, it is a good idea to add a risk premium to Treasury yield while comparing it with the earnings yield of a stock or the broader market.
The Winning Strategy
We have set Earnings Yield greater than 9% as our primary screening criterion, but it alone cannot be used for picking stocks that have the potential to generate solid returns. So, we have added the following parameters to the screen:
Estimated EPS growth for the next 12 months greater than or equal to the S&P 500: This metric compares the 12-month forward EPS estimate with the 12-month actual EPS.
Average Daily Volume (20 Day) greater than or equal to 100,000: High trading volume implies that a stock has adequate liquidity.
Current Price greater than or equal to $5.
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