‘Earnings yield’ can be enlightening

Looking at a company’s price-to-earnings ratio, or P/E, to get an idea of its relative price, can be useful. Calculating the P/E’s inverse — the “earnings yield” — can be enlightening, too.

As an example, to calculate the P/E of McDonald Farms Inc. (ticker: EIEIO), you simply divide the current stock price by the annual earnings per share (EPS). If its current annual EPS is $2 and the stock is trading for $90 per share, the P/E is 90 divided by $2, or 45. While 45 seems steep, it’s not meaningful until you compare it with the P/E ratios of industry peers and consider the firm’s health, competitive position and growth prospects. A high P/E means the market is assuming rapid growth, which may or may not be reasonable.

To calculate McDonald Farms’ earnings yield, just reverse the P/E ratio, dividing the annual EPS by the current stock price ($2 divided by $90 equals 0.022, or 2.2 percent). Compared to risk-free Treasury bond rates of roughly 3 percent to 4 percent, this doesn’t seem a bargain. But remember: Whereas bond rates are fixed, earnings typically grow. If McDonald Farms is expected to increase earnings by 10 percent per year, in 10 years its EPS should grow to $5.19. Assuming we bought our shares at $90, the earnings yield for us has now become 6 percent, considerably better ($5.19 divided by $90 is 0.06).

It can be instructive to see how long it takes for the growing earnings yield to pass the current 30-year bond rate, which is now about 4.65 percent. McDonald Farms passes it in eight years.

If your desired rate of return for your invested dollars is 12 percent, it will take about 18 years of earnings growth before the earnings yield of McDonald Farms beats that target — if earnings actually grow at the estimated pace. You can probably find other investments that will get you there more quickly. With riskier companies, you might look for them to pass your target rate sooner rather than later.

One of many tools for investors, the earnings yield can help you think more clearly about your expectations for investments.

Ask the Fool

Q: How can I tell if a company pays a dividend? — D.B., St. Louis

A: You can call the company and ask, or look it up online or in newspaper stock listings. Instead of the dividend itself, many stock listings often include the dividend yield, which is the percentage of the current stock price being paid out annually in dividends. If there’s a yield, it means there’s a dividend.

To figure out the dividend from the yield, just take the yield and multiply it by the stock price. Let’s say that Rent-To-Own Underwear (ticker: EWWW) is trading at $60 per share and has a yield of 3 percent (which is 0.03). Multiply 0.03 by 60 and you’ll get 1.80, meaning that the company is currently paying out $1.80 each year in dividends per share. (Companies often pay dividends quarterly, so this would be $0.45 per quarter.)

If you’re looking for promising stocks that pay significant dividends, grab a free copy of our Motley Fool Income Investor newsletter at www.incomeinvestor.fool.com. And learn about dividend reinvestment investing at www.fool.com/School/DRIPs.htm.

Q: Is it smart to buy more shares of a stock when its price has fallen? — D.A., Norwich, Conn.

A: This practice is called “averaging down.” It’s often regrettable, because there’s frequently a good reason why a stock is dropping. There are some exceptions to this rule, though. For example, perhaps the entire market has swooned, taking your holding with it. Or maybe the market has significantly overreacted to your company’s latest news, sending its shares down to levels you don’t believe are justified. If so, you can snap up some bargain-priced shares. Before you average down on any stock, make sure you take the time to re-evaluate the business.

My dumbest investment

A few years ago I started investing on my own. I opened a brokerage account and bought several stocks. One of them cost me $4 per share.

I was new at this game, and the stock market was going wild. I received a mailing from a well-known investor. One of his suggestions was not to get greedy, and to sell stocks after a 1- or 2-point gain. I sold the $4 stock for $5 and then watched it go to $80. I’m glad I didn’t pay for that advice. — M.S., via e-mail

The Fool Responds: A warning against getting greedy is actually good advice. Money is often lost when we hang onto grossly overpriced shares a little too long, hoping to eke out a few more dollars of profit.

That said, it can also be unproductive to sell a stock just because it’s gone up a bit. Instead, regularly evaluate your holdings to see if any are no longer poised to keep growing in a healthy manner. Also, be wary of any stocks selling for less than $5 per share, as those are “penny stocks,” prone to manipulation, among other dangers.