Earnings Yield

Using the P/E ratio in-stock selection involves ranking stocks from highest value to the lowest. However, ranking zero and negative P/Es would rank them below the lowest positive P/E when they are actually the most costly.

A solution for this is to use an inverse price-to-earnings ratio. This inverse is earnings to price (E/P), known as the earnings yield.

Ranking by earnings yield from highest to lowest would correctly rank securities from cheapest to most costly in terms of earnings one unit of currency buys. 

Question

Which of the following is most likely a reason for using earnings yield?

1. Abnormally high prices.
2. Supernormal earnings.
3. Meaningless negative P/E ratios due to negative earnings.

The correct answer is C. 

Earnings yield is used because ranking zero and negative P/Es would rank them below the lowest positive P/E when they are actually the most costly. Ranking by earnings yield from highest to lowest would correctly rank securities from cheapest to most costly in terms of earnings one unit of currency buys. 

A is incorrect. Abnormally high stock prices are not a reason for using earnings yield over price to earnings ratio.

B is incorrect. Supernormal earnings are not a reason for using earnings yield in stock selection.

Reading 25: Market-Based Valuation: Price and Enterprise Value Multiples

LOS 25 (f) Explain and justify the use of earnings yield (E/P).